The Investment Think Tank: Theory, Strategy, and Practice For Advisers

432 Pages·2004·5.66 MB·English

by  Deena B. Katz

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PRAISE FOR
The Investment Think Tank
edited by Harold Evensky and Deena B. Katz
“A ll serious practitioners should take the time to read The Investment Think Tank.
Harold Evensky and Deena Katz have done it again with a book covering
topics important to our industry and critical to our clients’ financial success.”
CHARLIE HAINES, MBA, CFP
President and CEO, Charles D. Haines, LLC
“ It’s rare when pragmatism joins forces with pure science, but I expected no
less from this team. Harold Evensky and Deena Katz—masters of theory
and practice in financial planning—rounded up a winner’s circle of invest-
ment pros. There’s something here for even the most seasoned in the business.
And if you’re new at the game, pay close attention.”
JESSICA M. BIBLIOWICZ
President and CEO, National Financial Partners
“ For a variety of reasons, individual investors today find themselves facing a
growing need for sophisticated advice to help secure their family’s financial
well-being. Harold Evensky and Deena Katz have long been thought leaders
in this important area, and their book makes an important contribution by
shedding new light on many of its facets.”
MARTIN L. LEIBOWITZ
Managing Director, Morgan Stanley
Coauthor, Inside the Yield Book
“ Given the pressures, demands, and challenges of everyday business, financial
advisers can gravitate to formulaic solutions to financial planning. The panoply
of issues addressed by a host of financial professionals in The Investment Think
Tank should encourage advisers to consider the pitfalls in seeking panaceas,
to better understand the vast variety of issues involved with constructing a
financial plan, and to appreciate the fiduciary importance of understanding an
individual investor’s needs, objectives, and psychological concerns in the design
process. I salute Harold Evensky and Deena Katz for their continuing efforts to
improve the quality of the financial planning professional’s performance.”
THOMAS A. JAMES
Chairman and CEO, Raymond James Financial, Inc.
“A great read, packed with valuable information from some of the best minds in
the business.”
J. THOMAS BRADLEY, JR.
President, TD Waterhouse Institutional Services
Contents The Bigger Picture....................................................................232
PART 1 | THE PORTFOLIO.........................................1 The Early Years.........................................................................235
1. The Tax-Efficient Portfolio..................................................5
13.Downside Risk Measures: A Brief History.......................235
2. Death to the Policy Portfolio.............................................17 The Modern Era of Semivariance Research...............................237
Faulty Assumptions.....................................................................18 The Birth of the Lower Partial Moment....................................238
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Bad Science?................................................................................20 Utility Theory, or the Maximization..........................................240
Consultants’ Payday....................................................................23 of Economic Happiness.............................................................240
A Misunderstanding?...................................................................25 Using LPM Measures Means Algorithms...................................242
Investment Policy........................................................................28 Recent Research in Practitioner Literature.................................246
Misrepresentation........................................................................30
Conventional Wisdom................................................................34 14. Fundamental Fund Analysis...........................................251
Fresh Start...................................................................................36 Deconstructing Portfolio Construction.....................................252
A New Set of Style Tools...........................................................255
3. A Holistic Approach to Asset Allocation............................39
Market Monitoring...................................................................263
Distinguishing Pretax Fund From After-tax Funds......................40
The Right Assets for the Family Portfolio....................................43
Mean-Variance Analysis...............................................................46 15. Controlling Longevity Risk in a Retirement Portfolio....265
Risk Factors in the Retirement Portfolio....................................266
4. Professional Portfolio Design.............................................53 Controlling the Risk Factors......................................................270
Current Portfolio Design.............................................................54 Optimal Allocation to Annuities...............................................277
Low Returns and Portfolio Design..............................................55
Core and Satellite: An Alternative Design....................................58 16. Monetary Policy and Investment Returns.......................281
Net Results..................................................................................62 U.S. Monetary Policy................................................................282
Appendix.....................................................................................65 The Life Cycle of Bond Returns................................................285
Core and Satellite: A Live Example..............................................65 Mechanics of Inflation-Indexed Bonds......................................287
PART 2 | STRATEGY................................................73 ILB Returns and the Monetary Cycle........................................288
5. Managing Concentrated Stock Positions............................77 Rhymes and Reasons.................................................................289
Sale and Diversification...............................................................78
Stock Options.............................................................................79 17. Defining Investment Advice...........................................291
Diversification and Deferred Compensation................................80 PART 5 | CLIENTS................................................317
Gift Strategies..............................................................................82
Alternative Strategies...................................................................84 18. Financial Gerontology and Employee Benefits...............321
The Wealth Span.......................................................................321
6. Managing the Taxable Equity Portfolio..............................89
The Four Stages of Tax Sensitivity...............................................90
An S&P 500 Investment...........................................................101 19. Assessing Risk Tolerance: A Micro-Behavioral Finance Case
Study...................................................................................331
7. Tax-Efficient Investing.....................................................101 Managing Risk Tolerance..........................................................333
Individual Stock Investments....................................................104 Defining Risk Tolerance............................................................334
Exiting a Stock Investment........................................................108 Assessing Risk Tolerance............................................................335
Recapping the Choices..............................................................124 Risk Tolerance Revealed............................................................340
Applying Risk-Tolerance Assessments........................................348
8. A Different Approach to Asset Location...........................125
The Way Ahead.........................................................................352
The Difference Method.............................................................126
Sensitivity Analyses...................................................................135
Summary of Case Studies..........................................................143 20. The Why of Wealth Management..................................357
The Wealth Management Index™............................................358
PART 3 | INVESTMENTS..........................................149 Getting to Why.........................................................................361
Promoting Wealth and Well-Being............................................365
9. Reinventing the Investment Fund....................................153
Structural Efficiency: Reducing Costs........................................154
A Comparison of Fund Structure Costs.....................................157 21. Lessons in Behavioral Finance........................................365
Silence Is Golden: The Stealth Index Fund................................164 Investors’ Quirks and Peculiar Traits..........................................368
An Integrated Investment Process .............................................167 About the Very Wealthy............................................................375
for Actively Managed Portfolios.................................................167 Fair Fees and Valuable Services..................................................376
Portfolio Management: Economics and Structure......................169
22. Missing Persons: Black Investors and the Stock Market..379
10. The Cost and Consequences of Insurance Wrappers.......179 The Problem, Its Origins, and Its Significance...........................380
Life Insurance Wrappers............................................................180 Tracking Progress .....................................................................380
Annuity Wrappers.....................................................................183 Changing the Face of an Industry..............................................384
Continuing Education Exam.....................................................387
11. Alternative Investments.................................................207
A Cautious Approach to Alternatives.........................................208
Index.........................................................................................395
Alternative Roles.......................................................................209
Absolute-Return Strategies........................................................211
Private Equity............................................................................214
Real Estate................................................................................215
The Advisory Firm’s Role..........................................................220
PART 4 | PRACTICE AND THEORY.............................221
12. Human Capital and Asset Allocation: Is That Client a Bond or a
Stock?..................................................................................225
Portfolio Diversification............................................................228
Employment Compensation......................................................231
Life Insurance............................................................................231
THE
Investment Think Tank
Also by Deena B. Katz
Deena Katz’s Tools and Templates for Your Practice
Deena Katz on Practice Management
Also available from Bloomberg Press
Hedge Fund of Funds Investing: An Investor’s Guide
by Joseph G. Nicholas
The PPLI Solution: Delivering Wealth Accumulation,
Tax Efficiency, and Asset Protection Through
Private-Placement Life Insurance
edited by Kirk Loury
Market-Neutral Investing:
Long/Short Hedge Fund Strategies
by Joseph G. Nicholas
Hedge Funds Risk Fundamentals:
Solving the Risk Management and Transparency Challenge
by Richard Horwitz
Wall Street Secrets for Tax-Efficient Investing:
From Tax Pain to Investment Gain
by Robert N. Gordon with Jan M. Rosen
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THE
Investment Think Tank
Theory, Strategy, and Practice for Advisers
edited by
Harold Evensky Deena B. Katz
and
BLOOMBERG PRESS
princeton
© 2004 by Harold Evensky and Deena B. Katz. “Managing the Taxable Equity Portfolio” © 2004 Para-
metric Portfolio Associates. “The Cost and Consequences of Insurance Wrappers” © 2004 Ben Baldwin.
“Controlling Risk in a Retirement Portfolio” © 2004 Ibbotson Associates. All rights reserved. Protected
under the Berne Convention. Printed in the United States of America. No part of this book may be repro-
duced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording, or otherwise, without the prior written permission of the publisher except in the
case of brief quotations embodied in critical articles and reviews. For information, please write: Permissions
Department, Bloomberg Press, 100 Business Park Drive, P.O. Box 888, Princeton, NJ 08542-0888 U.S.A.
The first part of Jean Brunel’s chapter, “The Tax-Efficient Portfolio,” is heavily inspired by Jean L.
P. Brunel, “A Tax-Efficient Portfolio Construction Model,” Journal of Wealth Management (Fall 2001):
43–50; and Jean L. P. Brunel, Integrated Wealth Management: The New Direction for Portfolio Managers
(Institutional Investor Books, 2002), chap. 6, pp. 102–111.
Most of the ideas presented in chapter 3, “A Holistic Approach to Asset Allocation,” by William
W. Jennings and William Reichenstein, are treated in their book Integrating Investments and the Tax Code
(John Wiley & Sons, 2003).
The ideas in Ross Levin’s chapter, “The Why of Wealth Management,” are developed from the
themes introduced in his book The Wealth Management Index (McGraw-Hill, 1997).
David Nawrocki’s chapter, “Downside Risk Measures: A Brief History,” is based on the article “A
Brief History of Downside Risk Measures,” which originally appeared in the fall 1999 issue of the Journal
of Investing. For more information, please visit www.iijoi.com.
Meir Statman’s chapter, “Lessons in Behavioral Finance,” appears with the permission of the CFA
Institute:
Copyright © 2002, the CFA Institute.
Reproduced and republished from AIMR Conference Proceedings
Investment Counseling for Private Clients IV with permission from the CFA Institute.
All rights reserved.
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First edition published 2004
1 3 5 7 9 10 8 6 4 2
Library of Congress Cataloging-in-Publication Data
The investment think tank : theory, strategy, and practice for advisers / edited by Harold Evensky and
Deena B. Katz.
p. cm.
Includes bibliographical references and index.
ISBN 1-57660-165-X (alk. paper)
1. Portfolio management. 2. Risk management. 3. Investments. 4. Hedge funds. I. Evensky, Harold.
II. Katz, Deena B.
HG4529.5.I587 2004
332.6--dc22 2004017389
For our parents,
Sylvia and Herbert Evensky
and Kenneth and Gladys Boone
C O N T E N T S
About the Contributors.........................................................ix
PART ONE | THE PORTFOLIO 1
1 The Tax-Efficient Portfolio.................................................5
Jean L. P. Brunel
2 Death to the Policy Portfolio............................................17
William W. Jahnke
3 A Holistic Approach to Asset Allocation...........................39
William W. Jennings and William Reichenstein
4 Professional Portfolio Design ...........................................53
Harold Evensky
PART TWO | STRATEGY 73
5 Managing Concentrated Stock Positions..........................77
S. Timothy Kochis
6 Managing the Taxable Equity Portfolio............................89
David M. Stein
7 Tax-Efficient Investing.................................................... 101
Thomas J. Boczar and Robert Gordon
8 A Different Approach to Asset Location......................... 125
Gobind Daryanani
PART THREE | INVESTMENTS 149
9 Reinventing the Investment Fund................................... 153
Gary L. Gastineau and Craig J. Lazzara
10 The Cost and Consequences of Insurance Wrappers......179
Ben G. Baldwin
11 Alternative Investments...................................................207
Mark Hurley