Statement of Investment Policy

Statement of Investment Policy

Project instructions:
Position: Portfolio Manager, CFA
Firm: Creative Investment Artists (CIA)

Situation: A potential new client has just been left $1,000,000 (on an after-tax basis) from a wealthy grandparent and is deciding between your firm and Blackrock Investment in terms of who will manage their new found wealth. As part of the process, the client would like you to put together a mock portfolio, detailing all potential assets to be included in the portfolio, as well as your forecast of the economy, markets, etc. and why CIA will provide a higher risk adjusted rate of return than other managers.

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Client: Your clients are Sam and Amy Kratchman both 39 years old (as of 4/1/14). They have two children, ages 10 and 7 and two dogs, Scooby and Shaggy.

Historical Savings and Real Estate: Sam and Amy were high school sweethearts and after finishing college, they decided to move to San Diego for warmer weather and great job opportunities. Each landed good jobs and via signing bonuses and graduation gifts, they were able to put away some money for savings as they knew they eventually wanted to get married, start a family and buy a house. In September 1997, they took $5,000 and bought 6 month treasury bills for liquid savings. At the same time, they decided on putting some money in the stock market. They had heard about a famous investor, Peter Lynch, whose philosophy was to invest in what you know. Both avid Coca-Cola drinkers, they decided to buy 50 shares of KO stock. While getting themselves situated in California, they continued to put away money. Every 6 months they would invest $1000 in t-bills, aIDing to their already established position and another 50 shares of KO, always reinvesting as they went along. This policy continued through the current day for KO but shifted for t-bills after the market crash (September 2008). Realizing they knew very little about investing they increased their semi-annual contributions by 5% each period through the current day.

In September, 2000 they decided to get married and rather than have a big weIDing, their parents offered to give them $50,000 for a down payment on a house. At the time, they weren?t completely sure where they wanted to live so they put the money in t-bills until they found the right home. Six months later, they found a great town home in La Jolla for $250,000 and used the $50,000 as a down payment on the home. At the time, they took out a 15 year mortgage at 6.75%.

In September, 2002, Amy got promoted and Sam changed to a much better paying job, thus enabling them to put away more money. Sam had a good friend who was always giving him stock tips. In September, 2002 they finally had the money and were able to take advantage of what they were told would be a ?sure thing.? (Never count on a sure thing) They bought 5,000 shares of Quantum Technologies, an up and coming company. In the next year the stock hovered around $2-3 but a one point dropped below $2. They decided to increase their position by another 2000 shares. Over the years 2003 and 2004 they saw the stock rise by well over 100% and were so excited but nervous at the same time. In November of 2003, the stock dropped below $7 and they decided to buy another 500 shares. In February 2004, they thought it wise to take some profits and try to diversify their investments. They sold enough stock to buy 500 shares in Apple ? a company they actually knew something about as they used many of their products (Boy- do they wish they bought more shares of Apple). After that period in time, Quantum did not perform well. Sam and Amy really knew nothing about the company, other than their friends tip and as they saw its value fall below $2 in 2006 they decided to sell 25% of their shares, putting the money into t-bills. They held onto the rest of their shares through the current time, always hoping it would actually come back ? although it never did.

By 2007, Sam and Amy were having their second child and decided they really wanted to be closer to their families on the East Coast. In May 2007, they sold their San Diego house and moved back to the Philadelphia area. They took the equity from their sale and aIDed it to their t-bill account as they knew they would need the money to buy another home. Amy was very pregnant at this point and with the real estate market a bit questionable, they decided to stay at Amy?s parent?s house until things settled down a bit. As their monthly expenses were far less because they weren?t paying a mortgage, they decided to buy stock in a company they both loved ? dollar tree. With the downturn in the economy, they believed sales at a ?dollar? store should do well. They figured out they were saving about $20,000 a year (with no mortgage payment) so in December 2007, March 2008, September 2008 and February 2009 they bought shares of Dollar Tree spending between $10,000-10,200 each time (buy round lots).

After about 2 years, they decided it was time to move into their own home. In April of 2009, they bought a $600,000 home in the suburbs of Philadelphia. They used all but $100,000 in their t-bill account as a down payment on a home. They felt mortgage rates would eventually come down, so they took out a 5/1 ARM at 5.95%. They know they?ll have to refinance in April 2014 but feel confident about their decision. As rates are in fact lower today, they would like to reinvest their mortgage savings into their investment portfolio. They would like you to find the best rate on a 30 year mortgage and then make extra payments once their second child is through college such that by the time they retire, all debt is paid off. They would like to retire by 65 years of age, but are willing to work longer to retire comfortably ? maximum age 68.

For tax purposes assume a 15% capital gains rate and 35% income tax rate. Every time a dividend or interest payment is received, it is taxed before being reinvested. The same assumption holds for all asset sales other than real estate. No taxes are paid on real estate if the gains are less than $500,000.

Currently the family is earning $300,000 per year (before tax), which adequately covers their daily living expenses and savings. They have been somewhat consistent in putting away money but are unsure if this needs to continue in the future and if so, how much they will need to save per year given their objectives. A random number should not be chosen but rather a well thought out savings plan if needed.

Sam and Amy want to pay for their children?s college education. You should assume the children attend college at age 18 and go to a four year institution. College currently costs $40,917 (private) and $18,391 (state). These amounts include tuition, room and board. You want to plan your future assuming full funding for both children?s college education. Average annual costs of education increase at 3.7% rate for private schools and a 3.2% rate for state schools.

In aIDition, they would like to buy a vacation house in Florida so they can use it all year round and are a lot less expensive than the Jersey shore. Homes they are looking at range in price from about $350,000 to $400,000. If needed, they are willing to rent out the house for 2-3 months at the most during the year. Assume at least a 20% down payment and finance the remainder.

In reviewing their current holdings they want you to calculate the average annual rate of return and risk on each investment they hold as well as the cumulative rate of return throughout their investment horizon. Given this information and your investment knowledge, make a determination whether these stocks and bills still hold a place in their portfolio. Diversification is very important so from the start, they do not want more than a 5% position in any one individual stock.

At the present time, they realize they made some mistakes with their savings decisions and were really lucky in others. Nothing about their past decisions have been consistent and although at times they were careful about putting money away, at others, they were not spending money on vacations, etc. They are seeking good advice for how to better diversify and make good informed investment decisions. They are so grateful to have just been left $1 million dollars and want to make sure they utilize their new found wealth so support their family?s future.

Your clients understand the risk/ return relationship and therefore do not want their nominal portfolio required return to exceed 10%, including your fee. Calculate required return using all the above data as well as aIDed facts listed in excel requirements.

Written Work:

1) Purpose / Objective
a. Purpose of paper and client?s objectives – should be done already
b. Risk and return of the portfolio
c. Assess current holdings including a calculation of the total return and risk as measured by standard deviation earned on each position. Should they hold onto these positions?

2) Economic Assessment: Completed already

3) Asset Allocation
a. Analyze why you chose this particular allocation
b. Explain how it makes sense given your client?s objectives and constraints including discussion about correlation and fundamental reasoning for your decisions
c. Include your portfolio risk adjusted return versus the overall market

4) Sourcing Requirements: Stated in previous handout

Excel Requirement:( i will put excel template on aIDitional materials)

Cash Flow Template

1) Retirement: retirement income is the future value on an after tax inflation adjusted basis. Calculate the average inflation rate over the last 20 years. When they retire they will need about 75% of their current income until age 79. Once at age 80, their travel will be more limited so will need about 45% of their income. We are assuming their health care coverage is provided in an ongoing way by their current employers. Plan for the couple to live to 95 years old (funds can be left to benefactors, if they should pass before then).
2) Calculate full amortization schedules for all mortgages, refinancing, etc. Mortgage rates are available on keeping in mind that a conventional loan maxes out at $417,000. Borrowing over that amount must be a jumbo loan. Make sure to take note of the points you are paying. Most of the time it makes sense to use zero point mortgages. YOU MUST USE PRINT SCREEN to source your actual rates. Print directly into a tab in your excel file.
3) Use appropriate housing indexes for their respective homes (stated in excel file mortgage tab).
4) If you choose to rent out their vacation home, assume the income generated must be after-tax and inflation-adjusted. Must source your assumption for rental income.
5) You must outline all your assumptions from your excel work and include as an appendix
6) The template provided must be completely filled in. AIDing is fine ? Deleting is not.

Asset Allocation Template

1) You need to use the historical average annual risk and return levels utilizing an appropriate benchmark for large, small and mid-capitalization domestic stocks, domestic fixed income, developed and emerging international equities, real estate, commodities and cash. You are required to invest in domestic stocks, domestic fixed income, international and cash.
2) The historical data should cover the period 3/31/1994 (20 year time period) to 3/31/2014 and 3/31/2004 ? 3/31/14 (10 year time period). Your data should measure total return (not just price) and all benchmarks must go back to 1994.
3) Asset allocation table must be 100% completed regardless of what sectors you choose to invest in. You must calculate a weighted return for your portfolio and make sure that it exceeds your nominal IRR by at least 25 to 50 basis points.


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