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© CANADIAN SECURITIES INSTITUTE (2017)

 INVESTMENT MANAGEMENT
TECHNIQUES

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ISBN: 978-1-77176-245-8

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Copyright © 2017 by Canadian Securities Institute

Preface
WHAT’S IN IT FOR YOU? OR, WHY IMT?
Capital markets move quicker and are more volatile than fifteen years ago. The investing public has access to
alternative asset classes such as commodities, private equity, real estate syndications and hedge funds. Investment
structures are more elaborate, making risk assessment difficult. The Investment Management Techniques (IMT®)
course can help you navigate retail client portfolios through these fast paced and complex markets. IMT builds
upon the foundation of knowledge set by the Canadian Securities Course. In addition to training on equity, fixed
income and mutual fund analytical methodologies, IMT presents knowledge to make qualitative assessments of
alternative asset classes and compare their investment structures. This will help you determine their suitability for
client portfolios. Investment Management Techniques also teaches you about risk reduction techniques using option
strategies.
Successfully managing retail client accounts involves not only good investing sense but good client relationship
skills as well. That’s why Investment Management Techniques also prepares you by teaching the principles of
behavioural finance to help manage client relationships.
As you advance in your financial career, Investment Management Techniques will provide the key to get you to your
next level. Earn credibility with clients, peers and employers by earning your Chartered Investment Manager (CIM®)
designation with completion of the Canadian Securities Course, Investment Management Techniques course, and
Portfolio Management Techniques course along with the required relevant work experience. You can also use your
CIM to attain the Fellow of CSI (FCSI®) — one of the most respected accreditations in the financial services industry.
Furthermore, completion of the CIM moves you towards satisfying Investment Industry Regulatory Organization
of Canada (IIROC) proficiency requirements to conduct discretionary portfolio management. Lastly Investment
Management Techniques can also be used to obtain credits to satisfy IIROC professional development requirements.
By advancing on investment management topics beyond the CSC and providing access to higher professional
licensing and designations, Investment Management Techniques is a way for a financial professional to get ahead.

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INVESTMENT MANAGEMENT TECHNIQUES

Content Overview

1 Investment Management Process

2 Understanding a Client’s Risk Tolerance
3 Asset Allocation and Investment Strategy
4 Equity Securities
5 Analysis of Equity Securities I: Economic and Industry Analysis
6 Analysis of Equity Securities II: Company Analysis and Valuation
7 Analysis of Equity Securities III: Technical Analysis
8 Debt Securities
9 Analysis of Debt Securities I: Valuation, Term Structure, and Pricing
10 Analysis of Debt Securities II: Price Volatility and Investment Strategies
11 Analysis of Conventionally Managed Products
12 Analysis of Non-Conventional Asset Classes and their Structures
13 Insurance-Based Investment Products
14 International Investing
15 Managing Your Client’s Investment Risk
16 Impediments to Wealth Accumulation
17 Portfolio Monitoring and Performance Evaluation
18 International Taxation

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Table of Contents
SECTION 1 | INVESTMENT POLICY

1 Investment Management Process

1•3 INTRODUCTION

1•3 WHAT IS THE INVESTMENT MANAGEMENT PROCESS?

1•4 Step One: Determine Investment Objectives and Constraints
1•5 Step Two: Create an Investment Policy Statement
1•5 Step Three: Establish a Strategic Asset Allocation
1•5 Step Four: Select Securities
1•5 Step Five: Monitor the Markets and the Client
1•6 Step Six: Evaluate the Portfolio’s Performance
1•6 Step Seven: Rebalance the Portfolio
1•6 WHAT INFORMATION IS REQUIRED BY REGULATION AND LAW?
1•6 IIROC Know Your Client (KYC) Rule
1•9 Federal and International Requirements
1•9 HOW DO INVESTMENT ADVISORS LEARN ABOUT THEIR CLIENTS?
1•9 Client Interviews
1 • 10 Client Questionnaires
1 • 11 Investor Behaviour
1 • 12 HOW DO INVESTMENT ADVISORS DETERMINE INVESTMENT OBJECTIVES AND
CONSTRAINTS?
1 • 13 Investment Constraints
1 • 20 Investment Objectives
1 • 27 HOW DO INVESTMENT ADVISORS CRAFT THE INVESTMENT POLICY STATEMENT?
1 • 28 Layout
1 • 28 Client Summary
1 • 28 Investment Objectives and Constraints
1 • 28 Portfolio Restrictions
1 • 29 Asset Allocation and Asset Location
1 • 29 Investment Philosophy (Strategies and Style)

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1 • 29 Schedule for Portfolio Reviews

1 • 29 Advisor/Client Agreement
1 • 30 WHAT COMMUNICATION SKILLS DO INVESTMENT ADVISORS NEED?
1 • 30 Interviewing Skills
1 • 35 Good Communication Skills
1 • 36 SUMMARY

SECTION 2 | UNDERSTANDING A CLIENT’S RISK TOLERANCE

2 Understanding a Client’s Risk Tolerance

2•3 INTRODUCTION

2•3 WHAT IS BEHAVIOURAL FINANCE?

2•3 Micro versus Macro
2•5 Standard Finance versus Behavioural Finance
2•6 WHAT IS THE RELEVANCE OF BEHAVIOURAL FINANCE TO THE INVESTMENT ADVISOR?
2•7 Understanding a Client’s Financial Goals
2•7 Maintaining a Consistent Approach
2•7 What the Client Expects
2•8 Ensuring Mutual Benefits
2•8 WHAT ARE RISK TOLERANCE QUESTIONNAIRES AND THEIR LIMITATIONS?

2 • 11 WHAT ARE INVESTOR BIASES?

2 • 12 Differences between Cognitive and Emotional Biases
2 • 12 Overview of Behavioural Biases
2 • 16 Identifying Behavioural Biases in Clients
2 • 17 Gender and Behavioural Finance
2 • 18 WHAT ARE INVESTOR PERSONALITY TYPES?
2 • 18 Eight Investor Personality Types (IPTs)
2 • 20 HOW DO INVESTMENT ADVISORS APPLY BIAS DIAGNOSES WHEN STRUCTURING
ASSET ALLOCATIONS?

2 • 22 SUMMARY

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SECTION 3 | ASSET ALLOCATION AND INVESTMENT STRATEGY

3 Asset Allocation and Investment Strategy

3•3 INTRODUCTION

3•3 WHAT CONSTITUTES AN ASSET CLASS?

3•3 WHAT IS ASSET ALLOCATION AND WHAT ARE ITS BENEFITS?

3•5 WHAT ARE ASSET ALLOCATION STRATEGIES?

3•5 Strategic Asset Allocation
3 • 10 Dynamic Asset Allocation
3 • 13 Tactical Asset Allocation
3 • 17 WHAT ARE EQUITY INVESTMENT STRATEGIES?
3 • 17 Passive and Active Equity Strategies
3 • 24 SUMMARY

SECTION 4 | EQUITY SECURITIES

4 Equity Securities
4•3 INTRODUCTION

4•3 SHOULD AN INVESTMENT ADVISOR RECOMMEND INDIVIDUAL EQUITIES OR

MANAGED PRODUCTS?

4•4 WHAT ARE THE CHARACTERISTICS AND FEATURES OF EQUITY SECURITIES?

4•4 Common Shares
4•6 Dividends versus Share Repurchase
4•7 Preferred Shares
4•8 WHAT ARE THE CANADIAN AND U.S. EQUITY MARKETS?
4•8 Canadian Stock Markets
4•8 U.S. Stock Markets
4•9 Recent Trends in Trading
4•9 HOW DOES AN INVESTMENT ADVISOR OBTAIN INFORMATION ABOUT EQUITY
SECURITIES?
4 • 10 Equity Research
4 • 13 Print Media and Television

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4 • 14 The Internet
4 • 15 SUMMARY

5 Analysis of Equity Securities I: Economic

and Industry Analysis
5•3 INTRODUCTION

5•3 WHAT IS ECONOMIC ANALYSIS?

5•3 Overview
5•3 HOW DOES AN INVESTMENT ADVISOR USE ECONOMIC ANALYSIS WHEN
DEVELOPING STRATEGIC AND TACTICAL INVESTMENT STRATEGIES?
5•4 Strategic and Tactical Investment Strategies
5•5 Cyclical Trends versus Secular Trends
5•6 Sources of Information
5•6 A Typical Session
5•6 WHAT ARE ECONOMIC FORECASTS?
5•7 Econometric Analysis
5•8 Consensus Forecasts
5•8 Deviations from the Consensus Forecast
5 • 10 WHAT ARE KEY ECONOMIC METRICS?
5 • 12 International Economic Developments and Events
5 • 13 WHAT IS INDUSTRY ANALYSIS?
5 • 13 Overview
5 • 14 Industry Classification
5 • 18 Industry Characteristics
5 • 20 Using Industry Analysis
5 • 22 SUMMARY

6 Analysis of Equity Securities II: Company Analysis

and Valuation
6•3 INTRODUCTION

6•3 WHAT IS THE DIFFERENCE BETWEEN IFRS AND GAAP?

6•3 WHAT IS COMPANY ANALYSIS?

6•3 Overview

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6•4 Sources and Analysis of Company Information

6•7 Qualitative Company Analysis
6•8 Financial Statement Analysis
6 • 10 Analysis of Earnings
6 • 14 WHAT MODELS CAN BE USED TO VALUE STOCKS?
6 • 14 Overview
6 • 16 Absolute Valuation Models
6 • 19 Relative Valuation Models
6 • 22 HOW ARE RESOURCE COMPANIES ANALYZED?
6 • 22 Oil and Gas Industry
6 • 27 Mining Industry
6 • 33 WHAT ARE THE LIMITS OF ACCOUNTING DATA?
6 • 33 The Accounting Issues
6 • 34 Motivations for Exaggerating Financial Records
6 • 35 SUMMARY

7 Analysis of Equity Securities III: Technical Analysis

7•3 INTRODUCTION

7•3 WHAT ARE THE BASICS OF TECHNICAL ANALYSIS?

7•3 Technical versus Fundamental Analysis
7•4 WHAT IS CHART ANALYSIS?
7•4 Types of Price Charts
7•7 Chart Patterns
7 • 17 WHAT IS STATISTICAL ANALYSIS?
7 • 18 Trend-Following Indicators
7 • 20 Momentum Indicators
7 • 22 WHAT ARE SENTIMENT INDICATORS?
7 • 22 Put/Call Ratio
7 • 22 Bullish and Bearish Consensus
7 • 22 Public Short Ratio
7 • 23 WHAT IS INTERMARKET ANALYSIS?

7 • 23 HOW CAN TECHNICAL ANALYSIS BE USED?

7 • 23 Market Timing

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7 • 24 Price Forecasting
7 • 24 Leading Indicator
7 • 25 HOW CAN TECHNICAL ANALYSIS AND FUNDAMENTAL ANALYSIS BE USED TOGETHER?
7 • 28 Problems with only using Technical Analysis
7 • 28 Problems with only using Fundamental Analysis
7 • 29 SUMMARY

SECTION 5 | DEBT SECURITIES

8 Debt Securities
8•3 INTRODUCTION

8•3 WHY INVEST IN DEBT SECURITIES?

8•3 WHAT ARE THE CHARACTERISTICS OF DEBT SECURITIES?

8•3 Issuers
8•5 Issuing Methods
8•6 Features
8•8 Price and Yield
8•8 Ranking
8•8 Types of Debt Securities
8 • 16 WHAT ARE THE RISK FACTORS OF DEBT SECURITIES?
8 • 16 Credit Risk or Default Risk
8 • 17 Additional Risk Factors
8 • 19 WHAT ARE THE TRADING MECHANICS OF THE DEBT MARKET?
8 • 19 Over-the-Counter Dealing Methods
8 • 20 Trading for Individual Investors through Investment Advisors
8 • 21 Fee Structures
8 • 23 SUMMARY

9 Analysis of Debt Securities I: Valuation, Term Structure,

and Pricing
9•3 INTRODUCTION

9•3 HOW ARE DEBT SECURITIES VALUED?

9•3 The Time Value of Money

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9•4 Strip Coupons

9•6 Bonds
9 • 14 Money Market Securities and Bonds with a Maturity of Less than One Year
9 • 17 WHAT IS THE TERM STRUCTURE OF INTEREST RATES?

9 • 19 HOW ARE DEBT SECURITIES PRICES DETERMINED?

9 • 20 Government of Canada Yield Curve Dynamics
9 • 29 SUMMARY

10 Analysis of Debt Securities II: Price Volatility and Investment

Strategies
10 • 3 INTRODUCTION

10 • 3 WHAT ARE THE KEY CONCEPTS RELATING TO BOND PRICE VOLATILITY?

10 • 3 Fundamental Relationships between Bond Prices and Yields
10 • 5 Measuring Bond Price Volatility: Duration and Convexity
10 • 13 Price Volatility of Bonds with Embedded Options
10 • 14 WHAT ARE DEBT SECURITIES STRATEGIES?
10 • 15 Active Strategies for Debt Securities
10 • 21 Passive Strategies for Debt Securities
10 • 22 Dedicated Strategies
10 • 23 International Investing
10 • 24 Evaluating the Different Management Techniques
10 • 25 SUMMARY

SECTION 6 | MANAGED PRODUCTS

11 Analysis of Conventionally Managed Products

11 • 3 INTRODUCTION

11 • 3 WHAT IS A CONVENTIONALLY MANAGED PRODUCT?

11 • 3 WHAT IS THE ROLE OF CONVENTIONALLY MANAGED PRODUCTS IN INVESTMENT

MANAGEMENT?

11 • 4 WHAT ARE MUTUAL FUNDS?

11 • 4 The Mutual Fund Organization: Trust Structure

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11 • 5 Due Diligence and Considerations for Investment Selection

11 • 10 WHAT ARE CLOSED-END FUNDS?
11 • 10 Closed-End Fund Discounts
11 • 11 The Use of Closed-End Funds in a Client Portfolio
11 • 11 WHAT ARE WRAP PRODUCTS?

11 • 12 WHAT IS OVERLAY MANAGEMENT?

11 • 12 Growth
11 • 12 Changes in the Role of the Advisor
11 • 13 Skills Required for Successful Overlay Management
11 • 14 Pros and Cons
11 • 15 Recent Trends in Overlay Management
11 • 17 WHAT ARE FEES AND TURNOVER?
11 • 17 Management Fees
11 • 17 Portfolio Turnover
11 • 18 WHAT IS THE RELATIONSHIP BETWEEN TAXES AND RETURNS ON CONVENTIONALLY
MANAGED PRODUCTS?

11 • 19 SUMMARY

12 Analysis of Non-Conventional Asset Classes

and their Structures
12 • 3 INTRODUCTION

12 • 3 WHAT IS AN ALTERNATIVE INVESTMENT AND WHY INVEST IN THEM?

12 • 3 WHAT ARE HEDGE FUNDS?

12 • 4 Hedge Fund Risk Drivers
12 • 4 WHAT ARE COMMODITIES?
12 • 4 Types of Commodities
12 • 5 Where Might Commodities Fit in a Portfolio?
12 • 6 WHAT IS REAL ESTATE?
12 • 7 Features and Characteristics of Real Estate
12 • 8 Return Characteristics of Real Estate and Mortgage Syndications
12 • 8 WHAT IS PRIVATE EQUITY?
12 • 10 Benefits and Risks of Private Equity Investing
12 • 11 WHAT ARE COLLECTIBLES?

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12 • 12 WHAT ARE THE WAYS TO INVEST IN ALTERNATIVE INVESTMENTS?

12 • 12 Hedge Funds
12 • 14 Asset Allocation and Hedge Funds
12 • 16 Commodities
12 • 16 Futures and Futures Options
12 • 19 Accessing Commodities Using Exchange-Traded Funds
12 • 21 Physical Commodities
12 • 23 HOW DO COMMODITY PRODUCERS MANAGE FINANCIAL RISK?
12 • 23 The Operational Nature of the Company
12 • 25 WHAT ARE THE WAYS TO INVEST IN REAL ESTATE?
12 • 25 Accessing Real Estate using Real Estate and Mortgage Syndications
12 • 25 Types of Real Estate Syndications
12 • 27 Evaluating the Risks and Benefits of Real Estate and Mortgage Syndications
12 • 28 How Real Estate and Mortgage Syndications Fit into a Client Portfolio
12 • 28 Accessing Real Estate using Mortgage-Backed Securities
12 • 29 Accessing Real Estate using Real Estate Investment Trusts
12 • 31 WHAT ARE THE WAYS TO INVEST IN PRIVATE EQUITY?
12 • 31 Direct Investing
12 • 32 Direct Funds
12 • 32 Fund of Funds
12 • 33 SUMMARY

13 Insurance-Based Investment Products

13 • 3 INTRODUCTION

13 • 3 WHAT ARE SEGREGATED FUNDS?

13 • 3 Maturity Guarantees

13 • 5 WHAT ARE GUARANTEED MINIMUM WITHDRAWAL BENEFIT (GMWB) PRODUCTS?

13 • 6 GMWBS’ Guarantees
13 • 7 Additional Benefits and Costs
13 • 9 Underlying Investments
13 • 9 Taxation Considerations
13 • 9 Suitable Investors and Account Types

13 • 10 SUMMARY

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SECTION 7 | INTERNATIONAL INVESTING AND TAXATION

14 International Investing
14 • 3 INTRODUCTION

14 • 3 WHAT IS THE THEORETICAL BASIS FOR INTERNATIONAL INVESTING?

14 • 4 WHAT IS THE SIZE OF GLOBAL EQUITY MARKETS?

14 • 4 WHAT ARE THE MAJOR INTERNATIONAL EQUITY BENCHMARKS?

14 • 5 MSCI EAFE
14 • 5 S&P Dow Jones Indices

14 • 6 WHAT ARE THE PRIMARY ADVANTAGES OF INTERNATIONAL INVESTING?

14 • 6 Diversification
14 • 6 Exposure to Emerging Markets
14 • 6 Exposure to Unique Companies

14 • 6 WHAT ARE THE PRIMARY DISADVANTAGES AND RISKS OF INTERNATIONAL

INVESTING?
14 • 6 Expenses
14 • 7 Liquidity Risk
14 • 7 Legal and Accounting Bases
14 • 7 Shareholder Communications
14 • 7 Foreign Exchange Risk
14 • 8 Sovereign Risk

14 • 8 WHAT ARE FOREIGN INVESTMENT VEHICLES?

14 • 8 Direct Investment
14 • 9 Mutual Funds
14 • 9 Exchange-Traded Funds (ETFs)

14 • 11 WHAT ARE THE SKILLS NECESSARY FOR EFFECTIVE INTERNATIONAL INVESTING?

14 • 11 Knowledge of Asset Allocation Tools
14 • 11 Sensitivity to Additional Costs and Expenses
14 • 11 Familiarity with Foreign Trading and Settlement Conventions
14 • 11 Sensitivity to the Different Volatility Levels of International Capital Markets

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14 • 12 DO ASSET ALLOCATION MODELS ASSESS INTERNATIONAL INVESTMENT

OPPORTUNITIES CORRECTLY?

14 • 13 SUMMARY

SECTION 8 | MANAGING YOUR CLIENT’S INVESTMENT RISK

15 Managing Your Client’s Investment Risk

15 • 3 INTRODUCTION

15 • 3 WHAT ARE INVESTMENT RISKS?

15 • 4 Inflation or Purchasing Power Risk
15 • 4 Credit Risk
15 • 5 Liquidity Risk
15 • 5 Currency Risk

15 • 5 HOW IS INVESTMENT RISK MEASURED?

15 • 6 Measures of Historical and Expected Risk
15 • 6 Popular Measures of Investment Risk

15 • 12 HOW CAN DIVERSIFICATION REDUCE INVESTMENT RISK?

15 • 12 Diversification and Correlation
15 • 13 Efficient and Naive Diversification
15 • 13 Dimensions of Asset Class Diversification
15 • 14 “Diworsification”

15 • 14 HOW CAN USING OPTIONS REDUCE INVESTMENT RISK?

15 • 15 Option Basics
15 • 17 Option Markets
15 • 17 Protective Puts on Individual Stocks
15 • 19 Protective Puts on Stock Portfolios
15 • 21 Covered Calls as a Hedge
15 • 23 Collars

15 • 25 HOW CAN USING FUTURES CONTRACTS REDUCE RISK?

15 • 25 Futures Basics
15 • 26 Reducing Portfolio Risk with Stock Index Futures

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15 • 28 HOW CAN USING CONTRACTS FOR DIFFERENCE (CFDS) REDUCE RISK?

15 • 28 Hedging with CFDs

15 • 28 HOW CAN USING PRINCIPAL-PROTECTED NOTES (PPNS) REDUCE RISK?

15 • 29 PPN Basics
15 • 29 Suitability of PPNs

15 • 30 SUMMARY

SECTION 9 | IMPEDIMENTS TO WEALTH ACCUMULATION

16 Impediments to Wealth Accumulation

16 • 3 INTRODUCTION

16 • 3 WHAT ARE THE BURDENS OF WEALTH ACCUMULATION?

16 • 4 Taxes
16 • 5 Inflation
16 • 6 Transaction Costs

16 • 6 WHAT ARE TAX MINIMIZING PORTFOLIO MANAGEMENT STRATEGIES?

16 • 6 Incorporating Tax Implications into Each Trade
16 • 8 Tax-Loss Harvesting
16 • 9 Crystallization
16 • 10 Selling Most Expensive Securities First
16 • 11 Reducing Yield and Turnover
16 • 11 Purchasing a Put Option

16 • 12 WHAT ARE TAX-EFFICIENT INVESTMENTS?

16 • 13 Exchange-Traded Funds
16 • 13 Index Funds
16 • 14 Active Mutual Funds
16 • 14 Tax-Sheltered Investments

16 • 16 WHAT ARE INFLATION SENSITIVE ASSETS?

16 • 16 Real Return Bonds
16 • 17 Real Estate as an Inflation Hedge
16 • 17 Commodities as an Inflation Hedge

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16 • 18 Collectibles as an Inflation Hedge

16 • 19 WHAT ARE COST-EFFICIENT INVESTMENTS?

16 • 20 SUMMARY

SECTION 10 | PORTFOLIO MONITORING, RE-BALANCING, & PERFORMANCE APPRAISAL

17 Portfolio Monitoring and Performance Evaluation

17 • 3 INTRODUCTION

17 • 3 WHAT IS PORTFOLIO MONITORING?

17 • 4 WHAT IS PORTFOLIO PERFORMANCE EVALUATION?

17 • 5 Performance Measurement
17 • 14 Performance Appraisal

17 • 26 SUMMARY

18 International Taxation
18 • 3 INTRODUCTION

18 • 3 INTERNATIONAL TAX CONFLICTS AND DOUBLE TAXATION

18 • 3 Exempt Income from Foreign Sources from Home Country Taxation
18 • 5 Anti-Avoidance Measures and Measure to Prevent Non-Declaration of Assets

18 • 5 SOURCES OF INTERNATIONAL TAX LAW AND THEIR INTERRELATIONSHIPS

18 • 5 Domestic Tax Law
18 • 5 International Tax Treaties
18 • 6 Interpretation of Tax Treaties
18 • 7 Special Treaty Meaning

18 • 7 JURISDICTION TO TAX
18 • 7 Residence of Persons and Domicile
18 • 8 Reconciling Conflicts of Residence for Individuals
18 • 9 Residence of Non-Natural Persons
18 • 9 Management
18 • 10 Gross or Net Taxation – Withholding Tax

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18 • 10 SOURCE COUNTRY TAXATION

18 • 11 Income from Immovable Property
18 • 11 Investments that Generate Dividends, Interest and Royalties

18 • 13 RESIDENCE COUNTRY TAXATION

18 • 14 Tax Relief Under Domestic Tax Law – Relief By Tax Credit
18 • 15 Tax Relief under Domestic Tax Law – Relief by Deduction
18 • 15 U.S. Treaties – Saving Clauses

18 • 16 SUMMARY

G Glossary

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 SECTION 1

INVESTMENT POLICY

1 Investment Management Process

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 Investment Management
Process 1

CONTENT AREAS

What Is the Investment Management Process?

What Information Is Required by Regulation and Law?

How Do Investment Advisors Learn About Their Clients?

How Do Investment Advisors Determine Investment Objectives and Constraints?

How Do Investment Advisors Craft the Investment Policy Statement?

What Communication Skills Do Investment Advisors Need?

LEARNING OBJECTIVES

1 | Describe the seven steps of the investment management process.

2 | Evaluate a client’s investment constraints.

3 | Evaluate a client’s risk and return objectives.

4 | Create an investment policy for an individual investor.

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 CHAPTER 1 | INVESTMENT MANAGEMENT PROCESS 1 •3

INTRODUCTION
Providing investment management services is more demanding today than ever before. The competition among
firms is fierce. New products and services are constantly being created to keep up with tax strategies and market
trends.
Investment advisors (IAs or advisors) must understand the foundations of the financial services industry, the
characteristics and features of all securities and various investment products, and the methods used to analyze
them. Although some clients may have some of these skills, they expect investment advisors, as professionals in
the field, to know more than they do about the art and science of investing. Advisors must also have a thorough
understanding of the investment management process, the Canadian regulatory system, and the importance
of ethics.
The investment management process consists of seven steps. The first two steps in the planning stage of the
investment management process are the determination of the client’s investment objectives and constraints, and
the development of the client’s investment policy statement (IPS). The IPS, the creation of which is possibly the
most critical of the seven steps, systematically lays out the information the investment advisor needs to know
to effectively manage the client’s portfolio and the roles and responsibilities of both the investment advisor and
the client.
After outlining the steps of the investment management process, this chapter will review the information
investment advisors need to know about their clients (and how they usually go about getting it) to develop an
effective IPS. Included in this section is a discussion of behavioural finance and personality profiling, two topics
that can help advisors understand why clients have the opinions they have and why they make the decisions
they do. A detailed discussion of investment objectives and constraints follows. The chapter continues with a
suggested format for the investment policy statement. Finally, the chapter concludes with a discussion on effective
communication skills an advisor can employ.

WHAT IS THE INVESTMENT MANAGEMENT PROCESS?

Investment management is an integrated and continual process designed to meet specific goals and objectives
within a set of constraints. The process consists of seven essential steps1 that, similar to many problem-solving
processes, can be grouped into the broader stages of planning, execution, and feedback.2

1
Other books may describe the same process consolidated into five or six steps.
2
Managing Investment Portfolios: A Dynamic Process, 3rd Edition, (AIMR, 2007).

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1 •4 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 1

Figure 1.1 | Stages and Steps of Investment Management Process

Determine investment objectives

and constraints.

Create an investment policy

Planning
statement.

Establish a strategic
asset allocation.

Execution Select securities.

Monitor the markets

and the client.

Evaluate the portfolio’s

Feedback
performance.

Rebalance the portfolio.

STEP ONE: DETERMINE INVESTMENT OBJECTIVES AND CONSTRAINTS

The first step in the investment management process is to determine the client’s investment objectives and
constraints. Investment objectives describe what a client is trying to achieve from the portfolio and are expressed
in terms of a return objective and a risk objective.
• The return objective states the annual return needed to meet the client’s goals. The return objective is
determined in part by retirement needs analysis.
• The risk objective defines the amount of risk the client can tolerate to meet the return objective. A client’s risk
objective is a function of their risk tolerance, which in turn depends on their willingness and ability to bear risk
in their portfolio.

Investment constraints help define not only the return and risk objectives, but also the securities in which the client
can and cannot invest. Investment constraints include the client’s time horizon, liquidity requirements, tax situation,
legal and regulatory requirements, and any unique circumstances.
Experienced investment advisors gather information about the client’s objectives and constraints by asking
questions and getting the client to complete a standardized questionnaire.

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STEP TWO: CREATE AN INVESTMENT POLICY STATEMENT

Most countries have a written constitution. Many companies have a formal mission statement. Each is intended
as a formal statement of guiding principles – the framework by which the country or the company intends to
operate. Each also, at least in broad terms, expresses a goal: “life, liberty, and the pursuit of happiness” or “complete
customer satisfaction.” Similarly, every investor should have a written investment policy statement (IPS). An
investment advisor can add value to a client relationship by creating such a statement for the client.
The IPS lays out, in a formalized manner, several key points. The first is a summary of the know-your-client
information gathered during meetings and distilled from questionnaires. The summary also highlights any other
information about the client that may have an effect on how the portfolio is handled.
The investment policy statement acts as the roadmap for achieving the client’s investment objectives. It includes
recommendations for an appropriate asset allocation, a suitable investment strategy (active, passive, or a mix of the
two) and possibly an investment style or philosophy (such as growth or value for equity securities, or interest rate
anticipation for debt securities), and identifies any specific investment restrictions (such as not investing in debt
securities with a credit rating below a certain level or not investing in certain companies such as tobacco firms).
Almost all institutional investors include in their IPS a range of minimum and maximum exposure to any asset class
at any given time.
Restrictions included in the IPS introduce a certain discipline into the investment process. An IPS that limits equity
exposure to, say, 60% of a portfolio can prevent investors from succumbing to the phenomenon known as chasing
returns, which means skewing their portfolio too heavily toward equities during a bull market.

STEP THREE: ESTABLISH A STRATEGIC ASSET ALLOCATION

Asset allocation means the proportion of the portfolio invested in each asset class. An asset allocation strategy
is usually specified in the investment policy statement. Although investment advisors may have the freedom to
recommend an array of individual securities (subject to any investment restrictions), the overall proportion of the
portfolio invested in cash, debt securities, and equity securities may be fixed. The asset allocation decision depends
on the client’s investment objectives and constraints, as well as the returns available from capital markets.
See Chapter 3 for more information on asset allocation.

STEP FOUR: SELECT SECURITIES

Many investors and investment advisors mistake security selection for investment management. Simply selecting
securities in the absence of the other steps is meaningless in the context of overall investment management. Still,
the investment management process is rendered pointless without the execution of the plan; security selection is
thus the pivotal step in the process.
Very simply, security selection is the step in which specific securities – stocks, bonds, managed products, or any
other investment vehicle – are chosen for inclusion in the portfolio.
The bulk of this text is devoted to the techniques and resources available to investment advisors when deciding on
which securities to include in client portfolios. Chapters 4 through 7 discuss equity securities, Chapters 8 through 10
focus on debt securities, and Chapter 11 is dedicated to conventionally managed products.

STEP FIVE: MONITOR THE MARKETS AND THE CLIENT

The job of investment management does not stop with the security selection stage. In a fluid world, circumstances
change: markets rarely, if ever, behave exactly as anticipated; client’s situations change; and no advisor, no matter
how talented, can expect or claim to make perfect investment choices all the time. Monitoring the markets and the
client’s situation is the key to ensuring that the investment management process is on track and achieving what it
set out to accomplish.

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Most investment dealers or investment management organizations have a wealth of information at their disposal,
including research reports, Bloomberg terminals, and investment industry journals. With the advent of 24-hour
a day business television and the plethora of mass investment-oriented newspapers and magazines, investment
advisors and clients alike have at their disposal more reliable information than ever before.
This democratization of investment information can be a double-edged sword. Information on financial markets,
world events, and new and innovative investment ideas is available on a scale and with a speed unimaginable
only a few years ago. But investors and advisors can be so overwhelmed with information that they succumb to
information overload and “paralysis by analysis.” Too much information can also lead to second-guessing well-
crafted investment recommendations.
Despite the dangers of information overload, monitoring is a vital part of the investment process. It is not enough to
leave a client’s account on autopilot once the portfolio has been constructed.

STEP SIX: EVALUATE THE PORTFOLIO’S PERFORMANCE

Periodically, but on a regular basis (for example, quarterly or annually), investment advisors must check the
performance of the portfolio to determine the returns earned and the risk level experienced, and compare these
results with equivalent figures for relevant standard or benchmark portfolios to establish whether or not the
portfolio is producing satisfactory results. In practice, annual evaluation should be the minimum standard.
Portfolio performance evaluation is discussed in Chapter 17.

STEP SEVEN: REBALANCE THE PORTFOLIO

Rebalancing is the final step in the investment management process and is closely related to monitoring and
performance evaluation. As financial markets and values change, their relative weights within client portfolios
change. Severe market swings can result in the actual weight of an asset class in the portfolio becoming significantly
different from the strategic weight established to meet the client’s long-term goals. Rebalancing simply reallocates
assets back to their originally intended portfolio weights by selling some of the ones that have performed well and
buying the ones that have done poorly.

WHAT INFORMATION IS REQUIRED BY REGULATION AND LAW?

IIROC KNOW YOUR CLIENT (KYC) RULE

Advisors are required to obtain certain information from their clients. IIROC-licensed Advisors are bound by IIROC’s
Client Relationship Model (CRM) and Know Your Client (KYC) Rules, as well as specific aspects of The Proceeds of
Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA).
IIROC Rule 1300.1 states:
Identity and Creditworthiness
(a) Each Member shall use due diligence to learn and remain informed of the essential facts relative to every
customer and to every order or account accepted.

Business Conduct
(o) Each Dealer Member shall use due diligence to ensure that the acceptance of any order for any account is within
the bounds of good business practice.

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Suitability Generally
(p) … each Member shall use due diligence to ensure that the acceptance of any order from a customer is suitable
for such customer based on factors including the customer’s financial situation, investment knowledge,
investment objectives and risk tolerance.

Suitability Determination Required When Recommendation Provided

(q) Each Member, when recommending to a customer the purchase, sale, exchange or holding of any security, shall
use due diligence to ensure that the recommendation is suitable for such customer based on factors including
the customer’s financial situation, investment knowledge, investment objectives and risk tolerance.

The CRM Rules require that this information be reviewed every time there is a trigger event. Trigger events include:
1. A trade is accepted,
2. A recommendation is made,
3. Securities are transferred or deposited into the account,
4. There is a change of representative on the account, or
5. There is a material change to the “know your client” information for the account.

Each IIROC Dealer Member shall use due diligence to ensure that the acceptance of any order from a customer is
suitable. The following variables relating to a client should be considered in determining whether a proposed trade
is suitable:
• Marital status;
• Age;
• Occupation;
• Income and net worth;
• Number of dependents;
• Risk tolerance;
• Investment objectives;
• Investment knowledge and experience; and
• Time horizon

The same information is required when recommending trades to clients (that is, solicited orders).
The regulation sets out the minimum amount of information that firms and their Advisors are expected to collect
from their clients (discount brokers have generally obtained exemptions from this rule because they do not provide
recommendations but execution-only services.). The requirements are collectively known in the industry as the
Know Your Client or KYC Rule. This rule is one of the cornerstones of the investment industry. The KYC rule has its
origins in the days when the business of investment dealers largely involved buying and selling securities on behalf
of clients. The information gathered allowed the firm and the Advisor to determine the suitability of each proposed
client trade, whether it was initiated by the Advisor or the client.
Recently, suitability requirements have been enhanced.
The primary form that is used to collect this information is known as the New Account Application Form (NAAF).
A sample of the NAAF can be found in the Forms section of the IIROC Rulebook. Each investment dealer uses a
slightly different variation of the NAAF to collect the information required under Rule 1300.1, but the content is
similar. Table 1.1 categorizes some of the information found on the NAAF by the due diligence factors suggested in
Rule 1300.1. Advisors must obtain this information whenever they open a new account for a client.

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Table 1.1 | KYC Information on NAAF

Personal Information • Name, address, phone numbers

• Date of birth
• Social Insurance Number
• Citizenship
• Occupation and employer’s name, address, and type of business
• Whether the client is an insider as defined by securities laws and subject to insider
trading rules
• If married, spouse’s name, occupation, employer, and employer’s type of business
• Number of dependants, if any

Financial Situation • Estimated net liquid assets and net fixed assets
• Approximate annual income from all sources
• Whether the client has, or has trading authority for, other accounts with the firm
• Whether the client has any accounts at other firms
• Bank reference
• Investment knowledge: sophisticated, good, limited, or poor/nil

Investment Objectives • Account objectives: percentage allocated to income and to short-, medium-, and
long-term capital gains

Risk Tolerance • Account risk factors: percentage allocated to low, medium and high risk

In addition to completing a NAAF for all new clients, Advisors should update existing NAAFs periodically. The form
should be updated whenever there is a major change in a client’s circumstances such as:
• Change of account name (i.e.: from “Marie Roy” to “Marie and Robert Roy”);
• Address change which would take a client out of Advisor’s jurisdiction;
• New marital or employment status;
• Another person who takes a financial interest in or who gains control over the account;
• New trading authorization;
• A major change in financial circumstances;
• New investment objectives or risk factors; or
• Any amendment to items in the regulatory section (i.e., insider status).

Any major change in circumstances could affect the client’s investment objectives, creditworthiness or risk
tolerance.
The information listed in Table 1.1 is the minimum requirement for identification and verification of all clients. IIROC
requires firms and Advisors to gather additional information, depending on the type of account.
• If the account is a joint account, complete personal information is needed from everyone named on the
account.
• If the account is a corporate account, personal information is needed for all individuals who beneficially own at
least 10% of the corporation.

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• If the account is a trust account, personal information is needed from the settlor and all individual beneficiaries
of more than 10% of the trust, whether directly or indirectly. Testamentary and publicly traded trusts are
exempted.

In addition to the NAAF, specific documentation is required when the client opens one of the following types of
accounts or trading in the following products:
• Joint account;
• Margin account;
• Discretionary account;
• Managed account;
• Trust account;
• Registered account;
• Investment club account; and
• Options or futures accounts.

Furthermore, the CRM Rules require that Member Firms provide each client a copy of their “know your client”
information.

FEDERAL AND INTERNATIONAL REQUIREMENTS

Firms and their Advisors must comply not only with IIROC Rules for the collection of client information, but also
with federal legislation and international agreements, particularly The Proceeds of Crime (Money Laundering) and
Terrorist Financing Act (PCMLTFA). This act requires the firm and Advisor to verify the client’s identity. There are
several ways to do this, including clearing a cheque written by the client or requesting a valid piece of picture
identification such as a driver’s licence or passport. In addition, firms must report any suspicious client transactions.
This information is needed to help prevent unscrupulous clients from using the financial system to hide the
proceeds of crime or to finance terrorist activity.

HOW DO INVESTMENT ADVISORS LEARN ABOUT THEIR CLIENTS?

CLIENT INTERVIEWS
Information gathering usually begins with a client interview during which the investment advisor can learn about
the client’s life and dreams and can identify any issues or problems. The initial interview is also a good opportunity
for the advisor and client to share their philosophies about investing to determine whether they will be able to work
together compatibly. For example, it may not be appropriate for an aggressive investor to have an advisor who is
used to dealing with conservative investors.
The investment advisor may find that some clients have difficulty expressing certain things in words. For instance,
while many individual investors know where they want to be financially in 10, 20, or 30 years, most have a hard
time explaining how much risk they are willing to accept to reach their goals.
To help obtain information that may not come out in an interview, most investment advisors and firms use a
standardized or customized client questionnaire.

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CLIENT QUESTIONNAIRES
Client questionnaires can be multiple choice (the client must select from a pre-determined list of responses) or
open-ended (the client must write down the answer). Some questionnaires focus on only one type of information
needed to develop a client’s investment policy, particularly the client’s attitudes toward risk, while others gather
a broader range of information. Risk questionnaires are popular tools because of the difficulty clients have in
expressing their tolerance for risk.

ADVANTAGES OF QUESTIONNAIRES

Questionnaires can be used to Clients need to be specific about their goals and to express which goals are more
specify and prioritize generic important than others. A questionnaire can help investment advisors figure out
financial and lifestyle goals. what clients are hoping to achieve and the priority they place on their goals.

Questionnaires can be used Some questionnaires can uncover inconsistencies in a client’s understanding of a
to pinpoint areas for client certain topic. Questionnaires may do this by asking the same question more than
education. once but worded differently in each case. For instance, if the response to one
question shows that the client has a high tolerance for risk, while another shows
that the client does not want to lose any of his principal, the investment advisor
knows that the client will have to be educated about the relationship between
risk and the possibility of losing money.

Family members can fill out Using separate questionnaires can identify potential conflicts between two or
additional questionnaires. more family members. An effective investment policy must reflect the situations
and goals of all family members, not just one.

If separate questionnaires identify potential conflicts, the advisor must ensure the conflicts are resolved before the
investment policy statement is completed.

DISADVANTAGES OF QUESTIONNAIRES

Clients may not understand When this happens, the questionnaire results may be of little value. Investment
some of the questions or may advisors should not make the mistake of assuming that their clients are as
think they understand them knowledgeable about investing as the investment advisor. This is of particular
when they do not. concern with new and relatively unsophisticated investors.

Clients may think they can Common questions ask clients to describe how they would react if a certain
predict how they will react event occurred, such as a sharp decline in the market. Although clients may
in certain instances, but real- respond that they would not panic in such a situation, when an actual market
life situations may produce decline occurs, many investors are less bold than they thought they were.
entirely different actions.

Questionnaires are based on Investors tend to compartmentalize their money into different accounts
the assumption that clients for different purposes, each with its own set of goals and risk tolerances.
take a holistic approach to Questionnaires, on the other hand, apply a single set of questions to all client
their assets. accounts as if each investor viewed all assets in the same way.

Despite these limitations, questionnaires can be useful. The questions may provoke discussions between clients and
investment advisors that are more important than the clients’ questionnaire responses. More often than not, the
follow-up discussions are aimed at defining a client’s true tolerance for risk.

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INVESTOR BEHAVIOUR
Even though each individual is different, research has shown that people tend to make important investment
decisions in ways that are not always consistent with most theories of investment management. Many of these
decision processes have to do with how an individual defines risk, and investment advisors should be aware of these
processes when developing a client’s investment policy.

BEHAVIOURAL FINANCE
Economists and mathematicians are not the only academics interested in investment management; human
psychologists have also made significant contributions, especially over the past 25 years. The field of behavioural
finance, advanced most notably by Amos Tversky, Daniel Kahneman, Meir Statman, Hersh Shefrin, Robert Thaler,
and Robert Shiller, is the study of how human psychology affects an individual’s investment decision-making
process. Behavioural finance challenges much of what economists and investment theorists, who study what is
sometimes called traditional or standard finance, have to say about how individuals make investment decisions.3
Standard finance assumes that investors:
• Are risk-averse
• Have rational expectations
• Manage their portfolios as a whole

Behavioural finance, on the other hand, suggests that investors:

• Can be risk-averse or risk-seeking, depending on the situation
• Have biased expectations
• Practice mental portfolio accounting

Investment advisors should understand some of the key points of behavioural finance and how they may affect a
client’s investment policy. The following discussion provides more detail about the primary differences between
standard and behavioural finance.

RISK AVERSION VERSUS RISK SEEKING

In standard finance, investors are assumed to be risk-averse, that is, given the choice between two investments with
identical expected returns, they will invest in the one with the least amount of risk, as measured by the standard
deviation of returns (standard deviation will be discussed in greater detail in Chapter 15). But, in real life, when
faced with the possibility of a loss, people are often risk seeking rather than risk averse.
When dealing with gains, people tend to be risk averse, but when dealing with losses, they tend to be risk seeking.
This asymmetric attitude toward risk can help explain why some investors are unwilling to sell securities that have
gone down in value. Rather than sell and realize the loss, investors hold on in the hope of a recovery, even if there is
a chance that the loss could become even bigger.

BIASED EXPECTATIONS
Standard finance assumes that investors have rational expectations, that is, they all gather and act on information
in an efficient and unbiased way. Behavioural finance claims that most people vastly overstate their abilities. The
classic example comes from a magazine study published a number of years ago. In it, a group of adult men were
asked three questions:
• How would you rate your ability to get along with others?

3
Amos Tversky, “The Psychology of Decision Making,” Behavioral Finance and Decision Theory in Investment Management. Charlottesville,
Association for Investment Management and Research, 1995.

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• How would you rate your ability as a leader?

• How would you rate your athletic ability?

All the men answered that they were in the top quartile in terms of their ability to interact with others, and no fewer
than 25% said they were in the top 1%. A full 70% of the men placed themselves in the top quartile of leadership
ability, and 60% answered that they were in the top quartile as athletes.
The message is clear: people are usually poor judges of their own abilities. Investment advisors must keep this in
mind when they assess client responses to questions in interviews and on questionnaires. Overconfidence may
cause investors to believe they are more tolerant of risk than they really are.

MENTAL ACCOUNTING
Standard finance assumes that investors consider their entire portfolio when they make decisions. Behavioural
finance, on the other hand, suggests that people compartmentalize their portfolio into different accounts. Mental
accounting refers to the phenomenon whereby people do not treat their assets as a single portfolio, but keep track
of them separately. In practical terms, this means that an investor who made $6,000 investing in one stock, but lost
$5,000 investing in another, is likely to dwell on the $5,000 loss, despite the fact that the investor’s overall wealth
increased by $1,000.
The topic of biases, mental accounting and other aspects of behavioural finance will be covered in greater detail
in Chapter 2.

HOW DO INVESTMENT ADVISORS DETERMINE INVESTMENT

OBJECTIVES AND CONSTRAINTS?
Once an investment advisor is sure that he has a complete understanding of the client’s personal and financial
situation, personal and financial objectives, and attitudes toward risk, he can begin crafting a specific set of
investment objectives and constraints. One of the core components of an effective investment policy is a clear and
well-written set of investment objectives and constraints.
All the information learned from the client through interviews, questionnaires, and follow-up discussions should be
distilled into two investment objectives:
• Return
• Risk

And five investment constraints:

• Time horizon
• Liquidity requirements
• Tax situation
• Legal and regulatory requirements
• Unique circumstances

Most investment policy statements state the return and risk objectives before describing the constraints. But the
objectives and constraints affect each other in so many ways that it is impossible to describe one without reference
to the other. The best way to begin the process is to identify the constraints, because the objectives – return and
risk – cannot be defined without knowing what the constraints are.
The client’s time horizon and liquidity constraints affect the risk and return objectives. They arise from the timing
and cash flow needs associated with client goals. The client’s tax situation and legal and regulatory requirements are

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external constraints imposed by the political, legal, and regulatory regime in which the client lives. The client’s tax
situation may dictate certain strategies, securities, or approaches to investing. Legal and regulatory requirements
can restrict a client from owning a type of security or limit the amount of a particular type of security that can be
owned. Legal and regulatory requirements can also restrict how a particular account, such as an RRSP, is invested.
The final constraint, known as unique circumstances, is a residual category that includes any constraint that cannot
be categorized as one of the previous four types. Examples include a client’s desire for socially responsible investing.

INVESTMENT CONSTRAINTS
TIME HORIZON
A time horizon is the length of time expected to elapse before one of the client’s significant goals must be met,
at which point the client will either withdraw some of the portfolio’s assets or enter a new stage of investment
planning that requires an update to their investment policy.4 Significant goals include the accumulation of a
nest egg for retirement, paying for a child’s education, or buying a vacation property. All clients have at least one
significant goal, but many have several; therefore, most clients have multiple time horizons and the portfolio must
be invested with each of them in mind.
Time horizons can generally be classified as short-term, medium-term, or long-term. There is no agreed-on
definition of how many years define a specific term, but short-term generally means less than 3 years, medium-
term generally means 3 years to less than 10 years, while long-term generally refers to 10 or more years.
Long-term time horizons are generally associated with a greater ability to bear risk. Since market cycles normally
last several years, clients with long-term horizons can better sustain the ups and downs of the markets than clients
with short-term horizons. However, not all clients with a long time horizon need to be exposed to higher risk.

EXAMPLE
Assume a 40-year-old client wants to accumulate a retirement nest egg in 20 years. This client’s primary goal, by
definition, has a long-term horizon, which suggests that the client could afford to assume a higher level of risk to
maximize the long-term return potential.
But suppose the same client also wants to pay for her 16-year-old daughter’s university education. She will need
the money starting in two years and continuing for the next four years thereafter.
Deciding which client goals should be recognized as a time horizon depends on how important the goal is to the
client and the size of the cash flow associated with the goal relative to the size of the client’s total portfolio.

Time horizon for a client is not always difficult to determine. Clients investing for their retirement usually have a
good idea of the age at which they want to retire – for example, at age 55, 60 or 65. For these clients, determining
the length of the retirement horizon is straightforward: simply subtract the client’s age from the desired
retirement age.
Clients may or may not precisely state other significant time horizons. For example, some may state a desire “to
buy a house in three years”, while others may say “to buy a house in three to five years”. In general, the sooner the
goal must be met, the more precise the client should be about its timing because it is harder to deal with a goal
that must be met “one to five years from now” than it is to deal with a goal that must be met “20 to 25 years from
now.” The client can still provide an estimate for shorter-term goals, but the estimate should cover a reasonably
narrow range (for example, “four to five years from now” rather than “one to five years from now”). To understand
the client’s time horizon constraint for each goal specified, the investment advisor needs to ask when the goal must
be met. If the client is not clear on timing, an advisor can try to help clarify through discussion. Otherwise, the client

4
Practically speaking, as the client approaches a defined time horizon, the investment policy should be reviewed more frequently than normal.
The impact of the looming change in investment policy is usually dealt with in steps until the horizon is reached.

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may find the timing becomes more clear having openly discussed the goal and will provide the information at a
later date.

LIQUIDITY REQUIREMENTS
Liquidity requirements represent the actual and potential cash needs of the client. They may dictate the need for
the client to own investments that can be converted to cash quickly, at minimum cost. Cost includes not only
commissions and transaction fees, but also implicit costs such as the bid-ask spread and the potential decline in the
price of an investment caused by selling it. This latter cost is known as market impact.

INVESTMENT LIQUIDITY
Not all investments offer ready liquidity. Real estate, for example, although it is an excellent long-term investment
in terms of both return potential and low correlation with other asset classes, is not very liquid. Although real estate
can be sold to raise cash, selling is not a quick process and there can be significant costs involved. The property
must normally be listed with an agent, titles must be searched, fees may be levied if a mortgage on the property is
discharged early, and finding a buyer may take months or even years. This lack of liquidity makes real estate entirely
unsuitable as a short-term investment.
Stocks, bonds, and most mutual funds, on the other hand, can usually be sold quickly when cash is needed. Explicit
costs such as commission are generally reasonable, but implicit costs vary. Shares in a company such as BCE or any
of the Canadian banks can be bought or sold readily, as the market is very deep, with many investors willing to buy
and sell near the most recent price. This is not the case, however, for other Canadian stocks, particularly small-
capitalization stocks. There is insufficient demand for these stocks, and trying to sell large quantities of them quickly
may lower the price received for the stock.
On major North American exchanges (TSX, NYSE), market makers are required to offer investors enough buying or
selling depth to fill relatively small orders at the current bid or ask price at any time of the trading day. On the TSX,
for instance, market makers must ensure that all orders are filled at the current bid or ask price for quantities up to
at least the stock’s designated minimum guaranteed fill (MGF) amount.
Investment advisors should understand that MGF amounts are minimums. The book of limit orders may contain
orders with enough depth to cover a client’s order, making it possible to get a fill at the current bid or offer price on
orders for more than the MGF amount. In most cases, investment advisors can determine the depth of a particular
stock on the TSX using a stock quotation service. Stocks with relatively small trading volumes, on the other hand,
can be costly in terms of market impact, and thus executing a trade may be unattractive.
Market impact on liquidity may take two forms. The first is a large bid-ask spread. Most of the heavily traded
large-cap stocks have a bid-ask spread of only a few cents, typically 5¢ or less. On a $30 stock, the difference in
percentage terms between a stock that is bid at $30 and offered at $30.05 is less than two-tenths of 1%. Lightly
traded stocks, however, may have much wider spreads in percentage terms. A stock which is bid at $4 and offered
at $4.20 has a spread of 5%, a significant cost.
The second form of market impact is the way in which large market orders can force prices up or down substantially.
Like the bid-ask spread, this is generally related to the typical volume in the stock. Stocks with lots of volume
normally have many buyers and sellers willing to buy or sell large quantities near the current bid-ask prices. Stocks
with substantially less volume have far fewer buyers and sellers. As a result, a large order will adversely move the
bid-ask spread against it. For example, a small capitalization stock trading at a bid-ask of $3–$3.30 may begin
trading at $3.10–$3.90 if a large buy order were to appear.
Liquidity varies for debt securities as well as stocks. Most federal and provincial Canadian bonds have excellent
liquidity in large quantities and are actively traded, which keeps bid-ask spreads down. Some corporate or municipal
issues, however, can suffer the same limited liquidity issues as stocks. T-Bills and money market instruments are
generally highly liquid, as are savings vehicles such as Canada Savings Bonds.

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PORTFOLIO LIQUIDITY
Clients usually require liquidity in their portfolios for one of three reasons:

Ongoing Income In this situation, the client relies on the portfolio as a source of regular income. Most
Needs clients who need cash regularly from their portfolio are retired. The need for regular
liquidity usually dictates a low tolerance for risk, but not always.

EXAMPLE
If the regular income represents such a small proportion of the portfolio that the portfolio could provide the
income even after a substantial loss of value, the client can tolerate greater risk. Of course, the client’s attitudes
toward risk and towards his or her goals will play a big part in determining exactly how much risk he or she can
bear.

Emergencies Many financial planning experts recommend that individuals have three to six months
of living expenses in cash (or near cash) in case of an emergency, such as job loss, illness,
or an unexpected sudden expense, such as an urgent home or car repair, or a medical
expense not covered by a provincial or employer health plan. Different clients need
different amounts of cash for emergencies. Investment advisors should inquire whether
the portfolio will be the source of the emergency reserve, or if it can be met by some
other source, such as cash in the bank.

Anticipated significant These purchases coincide with the client’s time horizon; if the nearest time horizon is
purchases a long-term one, the current need for liquidity is minimal.

Investment advisors should find out as precisely as possible the dollar amounts associated with known liquidity
requirements, including ongoing income needs and anticipated significant purchases. These amounts should
be noted in the liquidity constraint section of the IPS and will help advisors take appropriate measures at the
appropriate times.
The recommended reserve for emergencies may or may not be enough to cover the expenses associated with
an actual emergency because the cost of an emergency is unknown until it actually occurs. Since the timing of
emergencies cannot be predicted, planning for them is difficult. As a result, emergencies may require drastic
changes to the way the client’s portfolio is managed.

TAX SITUATION
An investment advisor needs to have a complete understanding of the client’s tax situation. This means, among
other things, knowing the client’s marginal tax rate, RRSP contribution limit, and any investment income being
earned in accounts not managed by the investment advisor. Once the advisor understands everything about the
client’s tax situation, she can suggest or implement investment techniques or strategies to reduce the client’s tax
payable.
Taxes on investment earnings reduce the amount of money available to meet the client’s goals. For clients who
need income from their portfolios on a regular basis, taxes reduce the amount of money available to pay current
expenses. For clients with longer-term goals, in non-registered accounts, taxes reduce the amount of money that
can be reinvested to meet future spending goals.

THE MARGINAL TAX RATE

An investor’s marginal tax rate is the top rate paid on taxable earnings and the rate at which the next dollar of
earnings would be taxed. The marginal tax rate includes both federal and provincial tax payable. Because provincial

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tax rates vary from province to province, the marginal tax rate differs for investors in each province. In addition, the
top marginal tax rate starts at different levels of income in each province because provinces also use different tax
brackets from those used by the federal government.
In Canada, investment earnings are taxed at different marginal tax rates. Although an individual can have one
average tax rate for all his income, the additional tax paid on the next dollar of investment returns depends on the
type of investment return:

Interest income Interest income originates from investments in debt securities and some managed
products. It is added to all other sources of income and is therefore taxable at the
investor’s marginal income tax rate. Individuals receive no tax relief of any kind when
it comes to interest income.

Realized capital gains Realized capital gains are effectively taxed at one-half the individual’s marginal income
tax rate because only one-half of all capital gains are taxable. For example, if an
investor has a marginal tax rate of 50%, the investor’s marginal tax rate on realized
capital gains is effectively 25%.

Unrealized capital gains Unrealized capital gains are not taxable. Taxable capital gains are generated only when
an investment is sold for more than was paid to buy it. If an investor chooses to hold
on to an investment, no capital gains tax is payable, no matter how much the security
has increased in value.*

Realized capital losses Realized capital losses offset realized capital gains. Therefore, only net realized capital
gains are taxable. That is, at the end of the year, the investor’s taxable capital gains
equal all capital gains realized during the year minus all capital losses realized during
the year. We will have more to say about this later.

Dividends Dividends from taxable Canadian corporations are subject to a gross-up and credit
system. The reason for the dividend tax credit system involves the issue of double
taxation: dividends paid by corporations are paid with after-tax dollars, meaning the
corporation has already paid tax on the income used to pay the dividend.

Dividends from foreign Dividends from foreign corporations are treated as regular income and are taxed at the
corporations investor’s marginal income tax rate.

* Managed products are an exception to this rule. If a managed product realizes capital gains from securities sold inside the managed product,
the fund distributes the capital gain to investors so that the managed product does not pay tax on the gains. Although an investor may not
have sold any holdings in the managed product, this realized capital gain distribution will be taxed in the hands of the investor who owns the
managed product on the date of the distribution.

Because of the different approaches to taxing different sources of investment returns, different marginal tax rates
exist for each type of earnings.
Since interest income is fully taxable at the investor’s marginal tax rate, interest-bearing investments are at a clear
disadvantage on an after-tax basis. In 2017, for eligible Canadian dividends, the gross up is 38% and the federal
dividend tax credit is 15.02% of the grossed up amount.

REGISTERED ACCOUNTS
For decades, Canadians have been able to contribute some of their annual earned income to a Registered
Retirement Savings Plan (RRSP). Making full use of available RRSP contribution room is one of the best tax
strategies most investors can use. For some high-income earners, RRSPs can help, but the overall effect on their
tax situation is not as great as it is for most other individuals. Registered Education Savings Plans (RESPs), Tax-Free

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Savings Accounts (TFSAs) and Registered Retirement Income Funds (RRIFs) are three other tools investors can use
to reduce their tax burden.

REGISTERED RETIREMENT SAVINGS PLANS

RRSPs are a type of tax-deferred account. Contributions to an RRSP are tax-deductible (they are deducted directly
from the individual’s income in a given year) and investment returns earned within the RRSP are not taxed in the
year that they are earned. Withdrawals from an RRSP are fully taxable at the investor’s marginal income tax rate.
There are no limits to the number of RRSP accounts an investor can open; however, there is a limit on the overall
amount that can be contributed in any given tax year. For the 2018 tax year, an investor’s maximum allowable
contribution is $26,230 or 18% of the investor’s 2017 earned income, whichever is less. The maximum is scheduled
to increase with the rate of inflation. Unused RRSP contribution room can be carried forward to future years.
Investors are allowed to make contributions to an RRSP until the end of the year in which they become 71 years of
age. At the end of that year they must terminate their RRSPs.
Termination of an RRSP can take the following forms:
• Transfer the RRSP’s cash value or all securities to a RRIF. This is the most tax-effective alternative for most
investors.
• Use the proceeds to purchase one of two types of annuities. A life annuity will pay the investor a guaranteed
annual taxable income either until the investor dies while a fixed-term annuity will pay the investor until the
investor reaches a specified age.
• Withdraw the entire value of the RRSP in cash or transfer all securities to a non-registered account. In this case,
the entire value of the RRSP as of the date of the withdrawal is included in the investor’s taxable income for
the year.

Termination is not an all-or-none decision; it can be a mix of the above three options. For instance, an investor can
withdraw some cash or securities, buy an annuity with part of the RRSP, and transfer the remainder to a RRIF.

REGISTERED RETIREMENT INCOME FUNDS

The primary advantage of a RRIF is that it allows investors to continue to invest in a tax-deferred manner. In other
words, investment returns earned within a RRIF are not taxed.
After the initial transfer of funds from an RRSP, an investor cannot make further contributions to the RRIF. Investors
must withdraw a minimum percentage of the RRIF’s value each year. There is no maximum to how much can be
withdrawn from a RRIF in any year.

REGISTERED EDUCATION SAVINGS PLANS

RESPs allow investors to save for a beneficiary’s post-secondary education.

Although contributions to an RESP are not tax-deductible, investment income earned within the plan is sheltered
from tax until it is withdrawn. When withdrawals are used to pay for the child’s post-secondary education, the
accumulated income is taxed in the hands of the child.
There is no maximum annual contribution limit to an RESP. The lifetime RESP contribution limit is $50,000 per
beneficiary. As an additional incentive to save, the federal government provides Canada Education Savings Grants
(CESGs). The maximum lifetime CESG per beneficiary is $7,200.
The CESG is calculated as 20% of the first $2,500 contributed to an RESP with enhancements to this amount being
available based on a family’s net income. For 2017:
• If net family income is less than or equal to $45,916, the grant is 40% of the first $500 of contribution each
year plus 20% of the next $2,000 of contribution made this year.

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• If net family income is greater than $45,916 and less than or equal to $91,831, the grant is 30% of the first
$500 of contribution each year plus 20% of the next $2,000 of contribution made this year.
• If net family income is greater than $91,831, the grant is 20% on the first $2500 of contributions made
this year.

The income thresholds for the CESG are updated each year.

TAX-FREE SAVINGS ACCOUNTS

A Tax-Free Savings Account (TFSA) was introduced in 2009. Investment income earned within a TFSA will not be
taxed. This is true whether the investment income was in the form of dividends, interest income or capital gains.
Capital withdrawals from the account are allowed at any time but the money cannot be placed back into the TFSA
until the following calendar year (otherwise you will have overcontributed).
Any Canadian resident at least 18 years old is eligible to open a TFSA. An individual’s contribution limit is $5,500
a year. The amount you can contribute is cumulative, indexed to inflation and rounded to the nearest $500.
There are drawbacks to the TFSA. Any realized capital losses incurred within a TFSA are not tax deductible. Unlike
an RRSP, contributions to a TFSA are not tax deductible. Interest on money borrowed to fund a TFSA is not tax
deductible.
A person who overcontributes to a TFSA is subject to a tax of 1% per month of the excess contribution.

DEALING WITH CLIENTS’ TAXES

The use of investment accounts, techniques, and strategies that aim to reduce or limit the amount of tax paid by
clients is known as tax management. Tax management includes various factors:

Making optimal use of For Canadian investors, this involves maximizing contributions to an RRSP or RESP, and
tax-deferred accounts making use of a RRIF when an RRSP must be terminated.

Making optimal use of For Canadian investors, this involves maximizing contributions to a Tax-Free Savings
a tax-exempt account Account (TFSA).

Optimizing the Tax-efficient allocation of assets between registered and non-registered accounts
allocation of assets is important. It may appear that investors should hold all their interest-bearing
investments in their RRSPs and TFSAs (because interest income is the highest-taxed
source of return and investment returns within an RRSP or TFSA are not taxed) and
hold all capital gains and dividend-producing investments in non-registered accounts.
However, there may be good reasons to hold interest-bearing investments outside
registered accounts or for holding capital gain–producing and dividend-producing
securities inside registered accounts. It all depends on the individual.

Make optimal use of In non-registered accounts, only net realizable capital gains are taxable; therefore,
capital losses investors can reduce their tax bill by using realized capital losses to reduce realized
capital gains. Any realized capital losses not used to offset capital gains in the current
year can be applied against capital gains from the previous three years or carried
forward indefinitely to offset capital gains in future years. When an investor faces a
potentially large tax bill as a result of a large number of realized capital gains, it may
be beneficial to sell some securities that have declined in value and that no longer
meet the criteria for inclusion in the portfolio.

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Keep turnover low Another way to reduce net realized capital gains is to follow a low-turnover strategy
in non-registered whenever possible. A low-turnover strategy involves minimizing the trading in an
accounts account to reduce the amount of realized capital gains.

Using life insurance On death, expenses such as capital gains taxes and probate fees are owed. The
proceeds to pay estate proceeds of a life insurance policy can be used to pay these expenses so that less of
taxes and fees the estate will be depleted and more will remain for the beneficiaries.

Income splitting and Income splitting is used to minimize current taxes or as part of a plan to transfer assets
attribution rules to one’s spouse and/or children. In general terms, income is diverted from a person in a
high tax bracket to a member of their family that is in a lower tax bracket.

Tax shelters Although tax shelters have been curtailed considerably in recent years by changes in
tax law and administrative practice, limited opportunities are still available. Before
considering a tax shelter, a taxpayer should be in a high tax bracket and have satisfied
basic consumption needs (such as food and shelter). The risks are high, and proper
accounting and legal advice is essential before a commitment is made.

A client’s investment policy should summarize their current tax situation and may include specific ways to deal
with taxes.

LEGAL AND REGULATORY REQUIREMENTS

Investing in Canada is a highly regulated activity. Although investment advisors need not possess a law degree,
there are three key areas that advisors should be comfortable discussing with clients.

RRSPs, TFSAs and RRSPs, TFSAs and RRIFs involve many regulations, including contribution limits and/or
RRIFs investment restrictions. There are also locked-in RRSPs that are created when investors
transfer money from a registered pension plan. Funds in a locked-in RRSP cannot be
withdrawn before the client reaches a certain age. Clients must be made aware of this
requirement when they transfer pension assets to one of these plans.

Company insiders In Canada, an insider is an individual who owns, directly or beneficially, more than 10%
of the shares of a public company. Such individuals are subject to restrictions in the
trading of their own company’s stock and are required to file regular reports of their
trading activity to securities commissions. This is an attempt to maintain the integrity
of capital markets by preventing insider trading, that is, trading with knowledge of
material, non-public information. Part of the know-your-client process should include
ascertaining whether the client is an insider as defined by securities laws and subject
to insider trading rules. Investment advisors must exercise caution when dealing with
company insiders and should consult with their firm’s compliance department before
executing orders by company insiders.

Conducting trades for Advisors should ensure that orders from industry personnel are clearly marked PRO.
investment industry Pro orders are always subordinate to client orders from the same firm: industry
personnel participants must not be allowed to have their orders filled prior to those of clients.
Again, the know-your-client process will help determine whether an order should
be marked PRO. At a time when the credibility of the industry and the profession
has been sullied by the unscrupulous actions of some in the investment industry, all
advisors must make sure that rules are followed, not only according to the letter of
the law, but also according to the spirit of the law.

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UNIQUE CIRCUMSTANCES
Unique circumstances are specific to each client and must be considered in the creation of an effective investment
policy. An example of a unique circumstance would be the desire for socially responsible investing. Some clients
refuse on personal ethical grounds to invest in particular companies, such as tobacco companies or companies that
operate in environmentally or politically sensitive areas. In addition, some clients insist that the companies in which
they invest adhere to an agenda that includes the humane treatment of workers and customers and meaningful
contributions to their communities. Mutual funds and exchange-traded funds (ETFs) exist that invest with an
agenda of social responsibility. While it is hard to tell whether socially responsible investing enhances or detracts
from long-term performance, it is clear that client preferences are a legitimate concern and must be taken into
account.

INVESTMENT OBJECTIVES5
The return and risk objectives must address the following questions:
• What rate of return does the client need to attain his goals?
• What risk are they willing and able to take to achieve those goals?

The insightful investment advisor will not settle for general statements such as “to make money,” or “to earn
the greatest possible return,” or “to protect capital.” These objectives are too vague to allow for the creation of
a meaningful investment policy. For instance, an investment objective such as “to preserve capital” could just as
easily be met by putting all of the client’s investment capital into a bank account. The capital is safe, at least to the
Canada Deposit Insurance Corporation–insured limit. Unfortunately, after inflation and taxes, bank deposits will
probably not preserve capital at all.
Appropriate investment objectives should state a specific return objective and a specific risk objective. For example,
“to earn a rate of return equal to 2% above the expected rate of inflation on an after-tax basis, while limiting losses
in any one year to no more than 15% of the portfolio’s value,” or “to earn a 7% nominal pre-tax return with a
moderate level of risk.” These specific statements offer the investment advisor a much better range of investment
options, thus increasing the likelihood of achieving the objectives.

RETURN OBJECTIVE
The return objective is a measure of how much the client’s portfolio is expected to earn each year on average. The
return objective depends primarily on the return required to meet the client’s goals, but it must also be consistent
with the client’s risk tolerance.
Before we address how the client’s goals and risk tolerance influence the return objective, however, we will discuss
how to measure the return objective.

MEASURING THE RETURN OBJECTIVE

The return objective should be measured by the portfolio’s expected annual total return, which includes all forms of
investment income (interest and dividends), as well as realized and unrealized capital gains.
Total return objectives can be stated in absolute terms, such as “9% per year”, or in relative terms, such as “the
expected annual inflation rate plus 3% per year” or “the annual benchmark return plus 2% per year”.
The return objective may include the expected effects of inflation and/or taxes. Return objectives may be stated on:
• an inflation-adjusted basis (before taxes but adjusted for expected inflation);
• an after-tax basis (before inflation but adjusted for expected taxes); or

5
This section draws heavily on Maginn, John L., Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto, “The Portfolio Management Process
and the Investment Policy Statement,” in Managing Investment Portfolios: A Dynamic Process, 3rd edition (CFA Institute, 2007).

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• an after-tax, inflation-adjusted basis (adjusted for expected inflation and taxes).

REQUIRED RETURN
The client’s required return is an estimate of the average annual return needed to meet all the client’s goals, taking
into consideration the client’s current and expected financial situation, including the amount of investable assets
and the timing and size of any expected additions to the portfolio (savings or any other source of new assets), as
well as current and expected future spending levels.

EXAMPLES
If a retired client’s primary goal is to receive an income from the portfolio to pay for living expenses then the
required return depends on the amount of investable assets as well as current and expected future spending
levels. Presumably, a retired client who requires income from their portfolio does not plan on adding more to the
portfolio in the form of savings, so portfolio additions do not affect the required return.
On the other hand, a client with a primary goal of saving for retirement will have a required return that depends
on the amount of investable assets, expected future savings, and expected future spending levels in retirement.

In addition to the client’s current and expected financial situation, the required return must also be sensitive to the
effects of expected inflation and taxes. For instance, a client’s expected spending levels are often stated in terms of
today’s dollars even though the actual spending will be done using future dollars. To take the effect of inflation into
account, expected spending should be adjusted for inflation, or returns should be expressed as real returns.

CALCULATING THE REQUIRED RETURN USING RETIREMENT NEEDS ANALYSIS

Retirement needs analysis requires completion of the following steps to determine the assets required at retirement
to generate income consistent with the desired retirement lifestyle.
1. Figure out periodic cash flow income required after retirement.
2. Figure out income from all sources after retirement.
3. Figure out the difference between 1. and 2., which is the shortfall or the surplus.
4. Figure out the assets required to cover the shortfall.

PERIODIC CASH FLOW REQUIRED DURING RETIREMENT

The first and most important step is figuring out how much income a client needs during retirement – the periodic
cash flow. There are three popular methods:
1. An itemized list of all expected expenses.
2. Net income, adjusted for pre-retirement expenses.
3. An estimated percentage of pre-retirement income.

The first method, itemizing all expected periodic expenses in line with the lifestyle needs identified through
discovery, is the most precise method (if future expenses can be estimated accurately, which can be very
challenging) and the most in line with the wealth management approach. It ignores the current reality of a client’s
expenses and income and focuses on the client’s dream. In this respect it can be called the Square One approach.
It is the most difficult and time-consuming method because it requires that the client and advisor understand the
costs of the dream and have the skills and patience to work through the calculations. There is also a dilemma with
this approach. While the closer a client moves toward retirement the more accurate the estimates can be with
respect to funding a retirement lifestyle, the proximity to retirement means that there is less time to accumulate
further wealth.

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The second method is a three-step process that is faster and easier than the first method. It is accurate for a rough
estimate of retirement cash flow needs, especially when the client does not have all the information, skills or
patience to go through the first method.
a. Add up the current after-tax income for both spouses.
b. Add up expenses that may vanish after retirement, such as RRSP contributions, additions to investments,
expenses related to work (commuting, buying lunch, parking), the mortgage on the house if it will be paid off
and expenses related to children or parents.
c. Deduct the pre-retirement expenses from current after-tax income to calculate after-tax retirement living
expenses. Estimate the income taxes for this amount of net income. Gross up living expenses to arrive at pre-
tax retirement living expenses (RLE).

Table 1.2 | Example of an Estimate of Pre-Tax Retirement Living Expenses

Husband Wife Total

Step A After-tax Income $ 85,000 $ 65,000 $150,000
Step B Deduct Expenses N/A after Retirement:
Mortgage $ 24,000
Children $ 18,000
Lunches, Commute, etc. $ 6,000
Retirement Savings $ 16,000
Total $ 64,000
Step C After-tax Retirement Living Expenses $ 86,000
Pre-tax RLE $123,000 *

* Assuming an average tax rate of 30%, [$86,000/(1 – 0.30)] = $123,000 (rounded)

This method can provide a good base from which the client and advisor can then incorporate aspects of the desired
retirement lifestyle that are not already accounted for in the base calculation.
The third method is the easiest one but also the most inaccurate. The assumption is that a certain percentage of
pre-retirement income, usually 70% is an acceptable estimate of the income required during retirement.
This percentage may vary between 50% and 90% of pre-retirement income and does not reflect whether or not
incomes are commensurate with the desired lifestyle needs of the retiree. This method is used to arrive at a rough
picture of the client’s profile.

PROJECTED INCOME FROM ALL SOURCES DURING RETIREMENT

The next hurdle is to estimate the income available after retirement. Add up all the projected government benefits
(CPP, OAS), company pension benefits, rental income, and life and term annuities. Do not include any income from
registered plans or open investment accounts because that is exactly what we are trying to calculate.

SURPLUS OR SHORTFALL OF CASH FLOW

The surplus or shortfall is calculated by deducting periodic cash flow required during retirement from projected
income from all sources during retirement. If the result is a positive number, then the client has a surplus and does
not need any periodic income from his registered plans or investments. If he has registered plans, he will still have

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to take out the legally required amount from his portfolio and pay taxes on it. He can then place the surplus into
open investments, help out his children and grandchildren, give to charitable organizations or spend.
If the result is negative, then the client has a shortfall and he needs to build savings that will generate periodic
income during his retirement, most likely for the rest of his life.

THE USE OF FINANCIAL PLANNING SOFTWARE

Calculating a required return that takes into account the effects of taxes, inflation, additional savings, and
anticipated withdrawals is not an easy task. Many investment advisors have access to software programs that,
given an estimated inflation rate and marginal tax rate, can figure out the average annual return needed to meet a
specified sum or series of income requirements on specific future dates.

CONSISTENCY WITH RISK TOLERANCE

Before a client’s required return is automatically accepted as the return objective, it must be checked for consistency
with the client’s risk tolerance. This requires a basic understanding of the historical risk-return trade-off of investing
in capital markets, as well as some expectations about future risk and return levels.

EXAMPLE
A client who requires an average annual return of 15% to meet all her goals might indicate that she has a very
low tolerance for risk. Clearly, this is unrealistic. Given historical trends, an average annual return of 15% can only
be expected if the client is willing to accept a very high level of risk.

If the client’s required return is inconsistent with his or her risk tolerance, something needs to change. Assuming the
risk tolerance is fixed, the typical solutions are to increase savings (or contributions to the portfolio) and/or decrease
expected future spending. If the client is not willing to do these things, and still wants to meet the required return,
then the client will have to accept a higher level of risk.
Even if the client increases the level of risk he or she will accept, or has a high risk tolerance to begin with, the
required return can only be accepted as the return objective if it makes sense in light of historical and expected
capital market returns.

EXAMPLE
Even if a client has a very high risk tolerance, an average annual return of, say, 30% is not reasonable.
The investment advisor must educate the client about achievable goals.

RISK OBJECTIVE
The risk objective is a specific statement of how much risk the client can sustain to meet the return objective. The
risk objective is based on the client’s risk tolerance, which in turn depends on the client’s willingness and ability to
bear risk.

CLIENT’S WILLINGNESS TO BEAR RISK

Pinpointing a client’s willingness to bear risk is a subjective exercise because different clients think about risk
in different ways. Unlike investment professionals, most investors do not think of risk in terms of the standard
deviation of returns. Most individuals also have a hard time expressing their attitudes toward risk clearly.

HOW INDIVIDUAL INVESTORS DEFINE RISK

In terms of portfolio performance, most individuals view risk in terms of losses. They consider risk to be losing
money or the probability of losing money.

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EXAMPLES
A client might say that he does not want to lose more than 10% of his portfolio in any given year. He considers
losses in excess of 10% to be risky.
Other clients might say that they don’t want their portfolios to have a greater than 10% chance of losing more
than 25%.

Individuals may also define risk in more qualitative terms. For some, risk is the probability of not meeting one or
more of their personal or financial goals. This is known as the risk of goal shortfall. For these individuals, meeting
their goals is extremely important, and their willingness to bear risk is limited by the need to meet these goals.

EXAMPLES
If a client has a goal of paying for a child’s post-secondary education, the consequences of not meeting this
objective are stark: either the child will not have the funds to go to college or university, or the client will have to
come up with more money, at an inconvenient time, to fund post-secondary education.
Another example is the risk of a retiree outliving his or her investment funds because the portfolio did not
generate a sufficient return to fund all retirement expenses.

Some individuals view risk in terms of uncertainty. Individuals may deem a particular market or instrument to
be too risky simply because they lack experience investing in the market or the instrument. Investment advisors
typically encounter this situation when they meet potential clients who have only invested in, say, bank GICs. These
people may find any type of equity investment just too risky.
Some clients consider buying foreign securities too risky. Many individuals do not take full or optimal advantage
of opportunities outside Canada because they are unfamiliar with how these markets operate, or they are not as
familiar and therefore not as comfortable investing in foreign securities as they are with Canadian securities. This is
called a home bias, in which individuals favour investments in their home market despite ample opportunities to
increase the efficiency of their portfolios.
Other qualitative aspects that may influence how much risk individuals are willing to bear include notions such as
regret and exclusion. Investors sometimes regret, or dwell on, past investing mistakes, which make them more
timid regarding future investment strategies. This regret may translate into a lower willingness to bear risk in the
future. Individuals also view risk as being excluded from, or missing out on, a rally in a particular investment or
asset class.

DETERMINING AN INVESTOR’S WILLINGNESS TO BEAR RISK

Figuring out how a client defines risk and exactly how much risk a client is willing to bear involves asking the right
types of questions during client interviews and on client questionnaires. Because it is hard to get clients to put
their attitudes toward risk into words, one of the primary goals of a client questionnaire is to pinpoint how a client
defines risk and how much risk they are willing to bear to achieve their goals. Rudimentary attitudinal questions
such as the following, found on most firms’ New Client Application Forms, tend to be ineffective.

Describe your tolerance for investment risk:

• Low

• Moderate

• High

Simply asking a client about an attitude may not produce an accurate response because the client may understate
or overstate their true view. This may be because the client has never really confronted the issue before and so

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has no frame of reference within which to answer the question. Moreover, attitudes on their own have few real
consequences. Most investors at least intuitively understand the link between return and risk, and focus not on the
risk side of the equation but on the return, claiming a higher willingness to bear risk than they actually possess. The
opposite can also happen, with investors claiming that they are more risk-averse than they really are.
Investment advisors should ask, and client questionnaires should contain, behavioural questions that seek to
model actual client actions in different circumstances, along the lines of “if this happened, what would you do?”
The following is an example of this type of question.

Suppose you bought a stock and the next day its price dropped 25%. Would you most likely:

a. Sell immediately to avoid further loss.

b. Buy more, it’s cheap!
c. Sell half the investment to limit my losses.
d. Do nothing.

This kind of question is better than an attitudinal one because it asks the client how they would behave in a specific
situation and offers several choices. A weakness of this type of question is that the client may still not answer
truthfully, especially in the case of a new investor with limited investment experience.
Typically, the answers to risk-based questions allow the assignment of different degrees of willingness to bear
risk. For instance, in the question above, if the client chose “option a) sell immediately”, they probably have a low
willingness to bear risk. By the same token, a client who would “buy more” may have an aggressive investment
personality and be prepared to buy on the dips. The other answers fall between these two extremes.
Once the investment advisor has the client’s completed questionnaire, he can use the answers to determine the
client’s willingness to bear risk, usually by applying a scoring system to the answers. A point value is assigned to
each potential answer. The following is an example of how the above question might be scored.

Suppose you bought a stock and the next day its price dropped 25%. Would you most likely:

a. Sell immediately to avoid further loss. 0 points

b. Buy more, it’s cheap! 5 points
c. Sell half the investment to limit my losses. 1 point
d. Do nothing. 3 points

The answer that represents the greatest willingness to bear risk is worth the highest number of points. The answer
that represents the next degree of willingness to bear risk is assigned the second-highest number of points, and so
on. The following shows how the point values for each question can be interpreted using the above scoring system.

Interpretation of scoring:

5 points = an aggressive investor

3 points = a moderate-risk investor
1 point = a cautious investor
0 points = a very conservative investor

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No single question can determine a client’s willingness to bear risk – clients will respond differently to different
situations. However, with the completed questionnaire, the investment advisor can determine a client’s overall
willingness to bear risk by adding up the points for each response and placing the client into a risk tolerance
category according to a key. For example, if the risk-based questionnaire had 10 questions on it, each with four
possible responses with point values similar to those above, the following could be the interpretation of the
overall score.

Interpretation of the overall tally:

35–50 points = an aggressive investor

20–34 points = a moderate-risk investor
6–19 points = a cautious investor
0–5 points = a very conservative investor

Specifying the client’s willingness to bear risk is like constructing a jigsaw puzzle: it is the intermingling of various
pieces of information that produces the final picture. For that reason, client questionnaires are the standard tool for
assessing a client’s willingness to bear risk.

CLIENT’S ABILITY TO BEAR RISK

Compared to the client’s willingness to bear risk, the client’s ability to bear risk is the result of more objective
factors. The ability to bear risk depends to some extent on the same factors that determine the required rate of
return. That is, the ability to bear risk is partly a function of the client’s current and expected financial situation,
including the amount of investable assets and the timing and size of any expected additions to the portfolio, as well
as current and expected future spending levels.
Once these have been determined, the ability to bear risk can be fine-tuned by finding out how important the
client’s goals are and how serious the consequences are if one or more of them are not met. If all the goals are
very important and there will be serious consequences if they are not met, the client has a lower ability to bear risk
because the repercussions of not meeting the goals are, in the client’s opinion, severe. On the other hand, if the
consequence of not meeting one or a few of the goals is not serious, the client has a higher ability to bear risk.

ESTABLISHING THE RISK TOLERANCE

An investor’s risk tolerance represents the combination of the investor’s willingness and ability to bear risk. If both
the investor’s willingness and ability to bear risk are low, then the investor’s risk tolerance is low; if they are both
high, then the investor’s risk tolerance is high. Problems can occur, however, when the client’s willingness to bear
risk is different from his or her ability to bear risk:
• If the client’s willingness to bear risk exceeds his or her ability to bear risk, the investment advisor needs to
educate him or her on the potential consequences of taking on excessive risk.
• If the client’s ability to bear risk exceeds the client’s willingness to bear risk, then the problem is less severe.
The client can be educated on the potential benefits of increasing risk within their ability to do so.

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EXAMPLES
A client who claims to be willing to bear a large amount of risk, and backs that claim up with a current portfolio
made up of highly speculative securities, may, in fact, have a short-term horizon with very modest return
requirements. The short-term horizon may be related to the client’s desire to save for a down payment on a
house in two years. In this instance, despite the client’s willingness or even eagerness to assume risk, the client
is not in a position to assume those risks because the possibility of failure to achieve the investment goal in the
relatively short time period available is too great, and the objective too important.
Investment advisors sometimes deal with the opposite situation: a client has a particular investment objective
that cannot be reasonably met, given the client’s low tolerance for risk. In this instance, the investment advisor
may have to reduce the client’s expectations of the portfolio or persuade him or her to assume a higher level of
risk to potentially generate high enough returns to meet the requirements.

DEFINING THE RISK OBJECTIVE

Once the investment advisor and client are satisfied that they have determined the appropriate risk tolerance, it
is necessary to explicitly state the risk objective. The investment advisor will need this information to recommend
an appropriate asset allocation for the client. In many cases, the investment advisor will identify several different
potential asset allocations, each with a different expected return and risk. Since the risk for each asset allocation is
usually stated in terms of its standard deviation, the investment advisor must determine which standard deviation is
consistent with the client’s risk objective.
Usually the client’s risk objective is stated in terms such as “average or moderate risk tolerance” or “lower-than-
average risk tolerance”. If these statements are consistent with the client’s return objective – and they should be –
then it is relatively easy to determine the appropriate standard deviation and asset allocation.

EXAMPLE
If an advisor had a client whose risk tolerance was “average” or “moderate” then the advisor would chose, from
his possible asset allocation mixes, the portfolio with a standard deviation in the middle of the available range. If
the standard deviations of the available asset allocations are 8%, 10%, 14%, 18%, and 20%, the allocation with a
standard deviation of 14% is likely to be appropriate.

If the client fully understands the concept of standard deviation, the risk objective can be stated as a specific or
maximum tolerable standard deviation.

EXAMPLE
The risk objective might be “a standard deviation of not more than 10%”.

This type of risk objective makes it easy to identify the appropriate asset allocation.
For clients who do not want their portfolio to decline more than a specified percentage, the risk objective can be
stated in terms of the maximum tolerable decline.

EXAMPLE
The risk objective might be “no more than a 20% decline in portfolio value in any given year”.

Once again, it is relatively easy to identify an appropriate standard deviation based on this risk objective.

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HOW DO INVESTMENT ADVISORS CRAFT THE INVESTMENT POLICY

STATEMENT?
The preparation of an investment policy statement is the culmination of a process that begins with a sometimes-
awkward first meeting and ends with mutual trust and a written agreement. The IPS describes the strategies and
steps the investment advisor will take to accomplish the client’s objectives. This makes the IPS a tool for managing
the client’s expectations and avoiding panicky or over-optimistic reactions to changes in the markets. By keeping
clients focused on their objectives, the IPS helps them meet those objectives.
Once established, the IPS becomes the link between the client’s objectives and the daily work of the investment
advisor. The soundness of the IPS depends on the clarity and rigour with which the objectives, constraints, and
investment guidelines are stated. You can test the quality and value of an IPS by asking five questions:6
• Is the IPS designed to meet the real needs and objectives of the client?
• Is the IPS written so clearly that a competent stranger could manage the portfolio in keeping with its
intentions?
• Would the client have been able to remain committed to the IPS during the actual conditions of the markets
over the past 50 or 60 years?
• Would the investment advisor have been able to remain committed to the IPS during the actual conditions of
the markets over the past 50 or 60 years?
• Would the IPS have achieved the client’s objectives under the market conditions of the past?

For an IPS to be appropriate, you must be able to answer yes to each of these questions.

LAYOUT
There is no standard format for an IPS. Regardless of the specific format, the IPS should have, at a minimum, the
following seven sections:
• Client summary
• Investment objectives and constraints
• Portfolio restrictions
• Asset allocation and asset location
• Investment philosophy (strategies and style)
• Schedule for portfolio reviews
• Advisor-client agreement

There is no standard length for an IPS; some may be as short as a few pages while others may run to dozens of
pages. As a principle, an IPS should be long enough to properly lay out how the portfolio will operate but not so
long as to be unreadable.

CLIENT SUMMARY
The client summary should contain most of the information in the client profile, which the investment advisor
should have prepared when working on the client’s investment objectives and constraints.

6
Charles D. Ellis, Investment Policy: How to Win the Loser’s Game (Business One Irwin, 1985).

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INVESTMENT OBJECTIVES AND CONSTRAINTS

The objectives and constraints should be in the form of clear, concise, unambiguous statements.

PORTFOLIO RESTRICTIONS
Restrictions fall into one of two categories:

Specific investment For example, if the client wants to be a socially responsible investor, this section will
constraints detailed under explicitly list the names of industries, sectors, or companies whose securities cannot
unique circumstances be included in the portfolio because of the socially responsible investing constraint.

General restrictions on the For example, a client may want to restrict the investment advisor from investing in
investments to be owned debt securities rated below BBB by a credit rating agency.
in certain asset classes

There may also be minimum standards for portfolio diversification. For example, a client may restrict the
investment advisor from investing more than a certain percentage in any one stock or more than a certain
percentage in any one industry.
This is an important section of the IPS because it is here that the investment advisor and client agree on how the
investment advisor will operate or make specific recommendations for the portfolio. The constraints thus establish a
benchmark for portfolio compliance.

ASSET ALLOCATION AND ASSET LOCATION

This section formally recommends an asset allocation strategy for the client’s portfolio. It should also recommend
an asset location strategy.
The recommended asset allocation is based on the client’s objectives and constraints. The asset allocation decision
also depends on the expected returns, risk, and correlation of asset classes (collectively known as capital market
expectations), as well as the range of assets allowed in the portfolio, which is spelled out in the portfolio restrictions
section.
Asset location refers to the division of assets among different types of accounts such as registered plans and non-
registered plans.

INVESTMENT PHILOSOPHY (STRATEGIES AND STYLE)

The investment advisor and client should agree on the investment philosophy used to select securities for the
client’s portfolio. The strategy can be active or passive. For the equity securities section of a client’s portfolio, active
strategies include bottom-up approaches and top-down approaches. The most common bottom-up approaches
are based on a specific investing style:
• Large-cap value
• Large-cap growth
• Small-cap value
• Small-cap growth
• A mixture of the four

Other bottom-up approaches include the pure fundamental, pure quantitative, and pure technical approaches.
These are discussed in greater detail in Chapter 3.

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Strategies and styles for debt securities are discussed in Chapter 10.

SCHEDULE FOR PORTFOLIO REVIEWS

Regular portfolio reviews give the investment advisor and client a chance to determine whether anything about
the client or the markets has changed that would warrant a change to the client’s IPS. Reviews are also the time to
assess the portfolio’s performance since the last review. Portfolio reviews and performance evaluation are discussed
in Chapter 17.

ADVISOR/CLIENT AGREEMENT
This final section of the IPS is essentially a sign-off page. It is critically important that the client sign the IPS to
indicate agreement with the contents of the document. Similarly, the sign-off process commits the advisor, in
writing, to recommend only investments specifically allowed by the IPS and to tailor their actions to the specific
agreed-on goals of the client. The signature page and advisor/client agreement should forestall disappointment,
misunderstanding, or disagreement between client and advisor.
The investment policy statement is perhaps the most important document exchanged between advisor and client,
and it is well worth extra care in its preparation.

WHAT COMMUNICATION SKILLS DO INVESTMENT ADVISORS NEED?

A good investment advisor is an investment expert but also a people expert and, most importantly, an expert in
translating the client’s investment needs into a suitable portfolio. Successful investment advisors use effective
communication skills to form strong working relationships with their clients so they can determine clients’
objectives initially and on an ongoing basis. Although effective communication skills will not guarantee that all
advisor-client relationships will be mutually beneficial, without these skills, good relationships are impossible.
Investment advisors need to communicate effectively with their clients for two distinct reasons:

To find out what the Although investment advisors must always act in the best interests of their clients,
client wants these interests are not always obvious. Advisors can determine their clients’ interests
only by talking to them and asking them questions. To understand a client’s objectives,
risk tolerance, and constraints, an advisor must use the techniques of interviewing
and active listening. Only then can they recommend appropriate investment vehicles.

To provide disclosure Investment advisors must be able to clearly explain their firms’ policies, their source
on all aspects of the of compensation, and the risks associated with any investment strategy, so that
business misunderstandings do not occur and clients have realistic expectations of their
relationship. Advisors should avoid jargon and present information in a way that
is appropriate to a client’s level of understanding. Proceeding at a suitable pace is
recommended, and getting feedback from the client is always helpful.

INTERVIEWING SKILLS
GUIDED DISCUSSION
The know-your-client rule means investment advisors need to gather information about their client’s investment
objectives, personal circumstances, and frame of reference. Advisors must guide the discussion to make sure that
they collect the required information. One way is to use a checklist and ask predetermined questions in order;
however, this rather impersonal approach does not help foster a close relationship with the client. Another way

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might be to let the conversation ramble on until the investment advisor has absorbed all the needed information;
however, this is a time-consuming, hit-and-miss approach, and the investment advisor might not cover important
areas.
The best approach is structured but informal. Investment advisors should keep in mind the kind of information they
need and guide the conversation so that they cover all relevant topics and gather a complete set of information.
This approach allows for the natural development of a personal relationship with the client. At times, however, to
ensure that necessary information is collected, investment advisors may have to probe the client.

PROBING
In probing, investment advisors use statements that require the client to respond with information. For example,
“It appears that your past experience includes some fairly risky investments, but this is in contrast to the way you
described your risk tolerance.”
Advisors may also ask direct or indirect questions. Direct questions seek immediate information and can be asked
when advisors feel that the issue will not be interpreted as too threatening or personal: “How old are your children?”
Indirect questions are useful when the client may be reluctant to divulge information or may interpret a direct
inquiry as too personal: “To make a recommendation, I need to know how much you have available each month to
invest.” This is less threatening than the direct question, “How much do you make and save each month?”
While probing, investment advisors should keep the following guidelines in mind:

Use both closed- Closed-ended questions seek specific pieces of information like, “What are your
ended and open-ended monthly income needs?” Open-ended questions invite clients to talk about
questions themselves and allow investment advisors to get to know them better: “Tell me
something about your past investment experience.” (This question is both indirect and
open-ended.)

Do not fire a barrage of Give them time to formulate thoughtful responses. The client should find the
questions at clients interview a positive experience – a friendly and useful conversation as opposed to an
interrogation.

Remember that a Investment advisors need to be ready to follow up on answers to questions if they feel
question’s usefulness that more can be learned: “It seems that one of your major concerns is taxation. Which
does not end when an tax bracket do you expect to be in when you retire?” (This follow-up, prompted by the
answer has been given answer to an initial question about the client’s objectives, is a direct, closed-ended
question.)

When asking for For example: “I realize this might be interpreted as a highly personal question, but
personal information, it is important that I know the answer if we are going to structure your investments
use a lead-in to properly, and I ask it only because of what you said previously. Do you foresee the
establish why they possibility of any significant change in your health?” If the investment advisor and the
need the information client have a well-established, open relationship, the advisor may be able to ask the
question more directly and not use such diplomatic language. However, if the advisor
is in any doubt about the client’s reaction, use caution and diplomacy.

TOWARD A WORKING ALLIANCE

Investment advisors who carry out questioning sensitively and thoughtfully come across as caring, competent
professionals who are guided by the highest ethical standards (honouring confidentiality, revealing potential
sources of conflict, disclosing compensation schemes, focusing on what is in the client’s best interest). Haphazard,

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unplanned interviews make an advisor appear to have little interest in getting to know and understand the client’s
particular needs.
In addition to gathering information about clients, effective communication skills help investment advisors forge
what Gerard Egan has called a strong working alliance with clients.7 The term describes the effort required of both
client and advisor and denotes a practical partnership.
Effective communication skills include the specific skills of attending, active listening, and empathy.

ATTENDING
The skill of attending requires more than just listening. Its goal is to help investment advisors convey to clients
that they respect their needs and are interested in helping them with their individual objectives. Perhaps the best
way to understand its importance is to imagine its absence. An advisor who does not attend to clients well will not
greet them in a friendly manner, will not be concerned about their physical and psychological comfort, and will
treat them as if they were one of many similar clients with identical needs. Clients treated in this way will not feel
satisfaction in their dealings with the advisor and may be less inclined to follow his or her recommendations.
Investment advisors show clients that they are attending to their needs by:
• Securing a comfortable and private area for conversation
• Routing incoming calls through voice mail or having an assistant take them
• Facing the client squarely and openly and establishing direct eye contact
• Focusing the conversation on the client’s needs and interests

The originator of client-centred therapy calls this, in the context of psychological counselling, showing positive
regard.8

ACTIVE LISTENING
To fully understand the practice of active listening, we need to examine the basic communication process. What
goes on in the simple act of communication?

THE PROCESS OF COMMUNICATION

The process begins when a sender decides to convey a message to a receiver. The sender chooses particular words,
symbols, or actions to encode or encrypt the message. These choices are influenced by any preconceptions the
sender may have. Part of the message may be encoded in non-verbal language, including facial expressions,
gestures, tone of voice, or body posture. Often the non-verbal part of a message is not consciously planned but
happens spontaneously, and conveys a good deal of information without the sender’s awareness.
Next, the sender must choose a medium of transmission, which may be written (a memo or letter), electronic
(fax or email), or oral (telephone or face-to-face conversation). Daft and Lengel rate media in terms of their
information richness.9 They suggest that the richest source of transmission is a face-to-face conversation because
audio and visual activity and non-verbal and verbal language occur simultaneously and feedback to the sender is
immediate and ongoing. Telephone conversations with clients, which are common in the investment industry, lack
the non-verbal dimension. Those who rely heavily on this medium convey less information per minute than they
would in person.
The message may contain both facts and emotions. The emotional component of the message may often be the
most important and may be conveyed by tone or inflection as well as in words.

7
Gerard Egan, The Skilled Helper, 5th ed. (Brooks/Cole Publishing Company, 1994).
8
C.R. Rogers, Client-Centered Therapy (Houghton Mifflin, 1951).
9
R. L. Daft and R.H. Lengel, “Information Richness: A New Approach to Managerial Behavior and Organizational Design,” Research in
Organizational Behavior. 1984, pages 191–233.

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EXAMPLE
A client who says, “I think I understand what you have been saying about the tax implications of strip bonds,”
may seem on the surface to be satisfied but may sound uncertain. You must decide whether to pick up on the
feeling and discuss the matter further to ensure that the client does not face an unpleasant surprise at tax time.

The receiver of the message has a much harder job than the sender. There are at least three aspects to listening:
decoding, assessing, and responding. To complicate matters, the message must pass through the receiver’s
preconceptions and compete with distractions. Seldom does an idea proceed directly from the sender to the
receiver so that it is understood exactly in the manner in which it was intended.
The first barrier a message must get past is the filtering caused by the receiver’s preconceptions, which include
biases, stereotypes, assumptions, or inferences. Preconceptions impose a meaning on the message that comes from
the receiver’s own experience, so what is received and understood may not be what was transmitted.

EXAMPLE
An advisor who perceives people of a certain culture or profession to be knowledgeable about financial matters
may assume that a client from one of these cultures or professions automatically understands the details of
the investment strategy. The advisor may ignore the client’s requests for explanations or any expression of
uncertainty.

Receivers may also fill in missing information with guesses about what was intended.

EXAMPLE
A client may talk about the need for income and the advisor may jump to the conclusion that they mean fixed-
income investments versus equity, in keeping with a certain risk preference. However, the client may have meant
monthly income, which might be in the form of interest, dividends, or periodic withdrawals.

Such guesswork can quickly derail smooth communication.

Distractions also keep the receiver from receiving the full message in its original form. Distractions may be external
noises in the office environment such as ringing telephones and other conversations, or internal preoccupations
with health, family, work, or other clients, that keep the receiver from concentrating fully on the sender’s words.
Once the message gets past preconceptions and distractions, the receiver must decode it and assess its significance.
Not all messages are of equal value. Some are just small talk and may be irrelevant to the issues at hand, such as
a story that the client wishes to share. (Remember, for some clients, conversing with an investment advisor is an
important social event.) Other messages, however, are relevant and contain information or requests that are central
to the client’s financial situation and the service the investment advisor offers.

ACTIVE LISTENING SKILLS

In assessing the significance of a message, investment advisors need to listen for the core meaning and relate it to
other information about the client before deciding on its significance and an appropriate response. The advisor’s
response may be casual if the message is merely social, or it may call for an opinion, a probe for further information,
or a paraphrase to let the client know they have understood the information. The advisor may also choose to say
nothing. Their response depends on their assessment of how much active listening is required.
The goal of listening actively is to gain a full understanding of the client’s world, including personal and financial
circumstances, financial objectives, values, constraints, and risk tolerance. To listen actively, investment advisors try
to answer the question: “What is it like to be the client?”

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One of the most useful techniques of active listening is paraphrasing and summarizing to let the client know that
they have been heard and that the advisor understands. The advisor can also use paraphrasing and summarizing to
encourage clients to reveal more about themselves and their situations.

To go back to the previous example, a client may talk about a need for income and an investment advisor
may be uncertain what the client means. The investment advisor can paraphrase: “You have indicated a need
for income. Income can take several forms. Are you speaking about monthly or annual income?” Depending
on the client’s response, the advisor may go on to clarify: “It often matters what form of income you receive.
Sometimes interest income is preferable to dividends or periodic withdrawals. Perhaps we might discuss the
form of income also.”

Be careful about interpreting non-verbal communication. Certain gestures and postures do not always translate into
the same meaning in all cases.

Scratching one’s head does not always mean one is confused. A flushed face does not always denote anger or
embarrassment. Cultural differences add to the interpretation problem. For example, in some cultures nodding
indicates agreement, in others it means disagreement.

Non-verbal language should be read as clues that might indicate attitudes that should, if they turn out to be
significant, be checked out by other means. Awareness of non-verbal communication is useful for at least three
reasons:
• It may indicate an internal conflict between what the client says and feels.

Arms folded tightly across the chest might indicate that the client is not as open to a recommended strategy
as their words suggest. This clue can lead to a useful verifying question such as: “Are you sure that this is one
hundred per cent OK with you?” This question might encourage the client to voice his or her reservations.

Verification is essential if the investment advisor is to understand the client and serve their best interests. Getting
the client’s honest reaction is important to avoid future misunderstandings or false expectations.
• Non-verbal language may indicate that the client has feelings that have not been expressed.

A repetitive tapping of the foot accompanied by a shifting forward and backward in a chair might indicate that
the client is impatient or in a hurry. You can check this out by asking: “How much time do you have today to
discuss this?”

• The client’s non-verbal language may provide clues about what the client thinks of you.

A relaxed posture might indicate comfort, whereas a contorted body position may suggest the client is
uncomfortable in your presence.

If the investment advisor picks up clues that suggest that the client is defensive, he should take remedial action.
Resistant clients may become more open to advice when the advisor uses indirect questions and active listening
skills.

EMPATHY
A skill related to active listening is the ability to empathize. Empathy is often confused with sympathy. Sympathy
means experiencing the same feelings as another person, but empathy is understanding how another feels without
needing to have the same experience. If you have never had the experience of having a close friend or family

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member die, it is impossible to sympathize with someone grieving, but it is possible to empathize. To empathize,
one must be able to enter imaginatively into another’s world to understand how the other person feels.
Many clients complain that financial professionals appear cold and technical when clients are struggling with
difficult emotions brought on by bereavement, sickness, or family upheaval. Investment advisors need to empathize
when clients are upset because of difficult personal situations. A client who appears sad and troubled needs to know
that the professional on the other side of the desk or at the other end of the telephone line cares and views the
client as more than just an account.
Empathizing involves not only listening to what the client is expressing, but also conveying to the client that they
have been understood. Investment advisors can do this by paraphrasing the client’s words or simply repeating
what the client has said in a thoughtful (not mechanical) way. Advisors should try not to make judgements about
what they hear. They should not rush to assure the client that all is well. It is more effective simply to let the client
know that you are listening and understand. Gerard Egan expresses it this way: “Empathy involves translating
your understanding of the client’s experiences ... into a response through which you share that understanding with
the client.”10

GOOD COMMUNICATION SKILLS

This way of looking at the process of communication suggests some principles for fostering good communication
skills. Investment advisors should:
• Speak clearly and slowly and be prepared to repeat what they say, particularly if the client has any physical
incapacity that limits their ability to hear or understand.
• Avoid jargon and choose language appropriate to the client’s level of understanding of investment-related
matters.
• Be aware of cultural differences that may affect communications, particularly non-verbal language that may be
interpreted differently in different cultures.
• Set aside any preconceptions when listening to clients, particularly about appearance, ethnicity, social
background, intellectual capacity, and age.
• Eliminate distractions from their environment as much as possible.
• Be committed to getting to know the client from the client’s point of view.
• Monitor non-verbal communication for possible meanings.
• Separate the content from the emotion of messages and analyze each one.
• Use empathy to make the relationship less distant.

10
Gerard Egan, The Skilled Helper, page 110.

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SUMMARY
By the end of this chapter, you will be able to:
1. Describe the seven steps of the investment management process.
• The first step in the investment management process is to determine the client’s investment objectives
and constraints. Investment objectives describe what a client is trying to achieve from the portfolio and are
expressed in terms of a return objective and a risk objective.
• The second step in the investment management process is to create an investment policy statement (IPS).
The IPS lays out, in a formalized manner, several key points. The first is a summary of the know-your-client
information gathered during meetings and distilled from questionnaires. The summary also highlights any
other information about the client that may have an effect on how the portfolio is handled.
• The third step in the investment management process is to establish a strategic asset allocation. The strategic
asset allocation (or investment policy asset mix) refers to establishing the long-term benchmark asset mix of
the various asset classes.
• The fourth step in the investment management process to select securities. Security selection is the step in
which specific securities – stocks, bonds, managed products, or any other investment vehicle – are chosen for
inclusion in the portfolio.
• The fifth step in the investment management process is to monitor the markets and the client. Monitoring the
markets and the client’s situation is the key to ensuring that the investment management process is on track
and achieving what it set out to accomplish.
• The sixth step in the investment management process is to evaluate the portfolio’s performance. Periodically
checking the performance of the portfolio to determine the returns earned and the risk level experienced, and
compare these results with equivalent figures for relevant standard or benchmark portfolios.
• The seventh step in the investment management process is to rebalance the portfolio. Rebalancing
reallocates assets back to their originally intended portfolio weights by selling some of the ones that have
performed well and buying the ones that have done poorly.

2. Evaluate a client’s investment constraints.

The five investment constraints are:
• Time horizon: A time horizon is the length of time expected to elapse before one of the client’s significant
goals must be met, at which point the client will either withdraw some of the portfolio’s assets or enter a new
stage of investment planning that requires an update to their investment policy.
• Liquidity requirements: Liquidity requirements represent the actual and potential cash needs of the client.
« Investment liquidity varies amongst the various investment products available.
« Portfolio liquidity is usually required by clients for one of three reasons: ongoing income needs,
emergencies, anticipated significant purchases.
• Tax situation: Taxes on investment earnings reduce the amount of money available to meet the client’s goals.
« Important areas to understand are the investor’s marginal tax rate and also the various tax management
factors such as making optimal use of tax-deferred accounts and tax-exempt accounts, optimizing the
allocation of assets, making optimal use of capital losses, keeping turnover low in non-registered accounts,
using life insurance proceeds to pay estate taxes and fees, income splitting and attribution rules, and tax
shelters.

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 CHAPTER 1 | INVESTMENT MANAGEMENT PROCESS 1 • 37

• Legal and regulatory requirements: Three key areas that advisors should be comfortable discussing with
clients are:
« RRSPs, TFSAs, and RRIFs.
« Company insiders.
« Conducting trades for investment industry personnel.
• Unique circumstances: Unique circumstances are specific to each client and must be considered in the
creation of an effective investment policy.

3. Evaluate a client’s risk and return objectives.

• Return objective: The return objective is a measure of how much the client’s portfolio is expected to earn
each year on average. The return objective depends primarily on the return required to meet the client’s
goals, but it must also be consistent with the client’s risk tolerance. The return objective should be measured
by the portfolio’s expected annual total return, which includes all forms of investment income (interest and
dividends), as well as realized and unrealized capital gains.
• Risk objective: The risk objective is a specific statement of how much risk the client can sustain to meet the
return objective. The risk objective is based on the client’s risk tolerance, which in turn depends on the client’s
willingness and ability to bear risk.

4. Create an investment policy for an individual investor.

The investment policy statement (IPS) describes the strategies and steps the investment advisor will take to
accomplish the client’s objectives.
• There is no standard format for an IPS. Regardless of the specific format, the IPS should have, at a minimum,
the following seven sections: client summary, investment objectives and constraints, portfolio restrictions,
asset allocation and asset location, investment philosophy (strategies and style), schedule for portfolio
reviews, and advisor-client agreement.

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 SECTION 2

UNDERSTANDING A CLIENT’S
RISK TOLERANCE

2 Understanding a Client’s Risk Tolerance

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 Understanding a Client’s
Risk Tolerance 2

CONTENT AREAS

What Is Behavioural Finance?

What Is the Relevance of Behavioural Finance to the Investment Advisor?

What Are Risk Tolerance Questionnaires and their Limitations?

What Are Investor Biases?

What Are Investor Personality Types?

How Do Investment Advisors Apply Bias Diagnoses When Structuring Asset Allocations?

LEARNING OBJECTIVES

1 | Describe the theory of behavioural finance.

2 | Explain the benefits of using the principles of behavioural finance when working with clients.

3 | Explain the drawbacks of traditional risk tolerance questionnaires.

4 | Identify cognitive and emotional client biases.

5 | Incorporate client bias diagnoses into strategic asset allocation discussions and decisions.

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INTRODUCTION
There are two camps in the world of finance. The first of these is standard finance, which embodies the notion
that investors are inherently rational economic beings. The behavioural finance camp holds that investors are
human beings, rather than idealized logical creatures, and therefore an investor’s personal beliefs and biases
influence their risk tolerance. The conversation about risk is one of the most important parts of the investment
advisor’s relationship with a client. This chapter takes a closer look at behavioural finance and its applications in
understanding a client’s risk tolerance.

WHAT IS BEHAVIOURAL FINANCE?

Behavioural finance is commonly defined as the application of psychology to understand human behaviour in
finance or investing. The term appears in many books, magazines and other media, but many people still lack a
clear understanding of the concepts behind behavioural finance or what it really means. One cause of this confusion
is that there are a number of disciplines resembling behavioural finance, such as behavioural science, investor
psychology, cognitive psychology, behavioural economics, experimental economics and cognitive science, to list
just a few. The discussion of behavioural finance can be split into two subtopics:
• Behavioural Finance Micro, which looks at the irrational behaviour of individual investors, and
• Behavioural Finance Macro, which looks at irregularities in the overall market.

MICRO VERSUS MACRO

Behavioural Finance Micro (BFMI) examines the behavioural biases (that is, irrational behaviours) of individual
investors. It compares irrational investors to rational investors envisioned in classical economic theory, known as
Homo economicus or “rational economic human being”. Behavioural Finance Macro (BFMA), on the other hand,
describes “anomalies” or irregularities in the overall market that contradict the efficient market hypothesis.
Many students of the securities markets are taught that markets are efficient. However, researchers have uncovered
abnormal market behaviours, such as the January Effect and others, that demonstrate that human behaviour
influences securities prices and therefore markets. For investment advisors, the primary focus of behavioural finance
is micro, or BFMI, the study of individual investor behaviour. Specifically, the investment advisor seeks to identify
relevant psychological biases her clients might have and to investigate their influence on asset allocation decisions,
so that she can manage the effects of those biases on the investment process and thereby help her clients meet
their financial goals.

EXAMPLE
A client who is subject to loss aversion bias will likely hold on to losing investments too long. If the advisor can
identify this bias in her client, she can help the client overcome this damaging behaviour and, therefore, make
better asset allocation decisions.

To gain an understanding of BFMI, the investment advisor must consider the central question of irrational versus
rational behaviour: do individual investors behave rationally, or do cognitive (relating to conscious intellectual
activity such as thinking, reasoning and remembering) and emotional errors influence their financial decisions?
Much of economic and financial theory is based on the notion that individuals act rationally and consider all
available information in the financial decision-making process. However, many researchers have documented
evidence of irrational behaviour and repeated errors in financial judgment. The most fundamental topic in
behavioural finance research is the classic debate of Homo economicus versus the behaviourally biased individual.

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RATIONAL ECONOMIC INDIVIDUAL VERSUS BEHAVIOURALLY BIASED INDIVIDUAL

First established in neo-classical economics, Homo economicus (or rational economic human being) is a model of
human economic behaviour that hypothesizes that three principles rule economic decisions made by individuals:
• Perfect rationality
• Perfect self-interest
• Perfect information

Homo economicus is a model that academics and practitioners believe in with varying degrees of stringency. A few
believe in a “strong” form, which holds that irrational behaviour does not exist. Others have adopted a “semi-
strong” form; this version sees an abnormally high occurrence of rational economic traits. Other economists support
a “weak form” of Homo economicus, in which the irrational traits exist but are not strong.
All of these versions share the core assumption that humans are “rational economic maximizers,” who are self-
interested and make rational economic decisions. Economists like to use this as a principle for two primary reasons.
First, Homo economicus makes economic analysis relatively simple. Second, it allows economists to quantify their
research findings, which makes their work easier to teach and disseminate. If humans are perfectly rational, possess
perfect information and display perfect self-interest, then perhaps their behaviour can be quantified.
Most criticisms of Homo economicus proceed by challenging the bases for these three underlying assumptions.

CRITICISMS OF PERFECT RATIONALITY

When humans are rational, they have the ability to make logical and self-interested judgements. However, many
would agree that rationality is not the sole driver of human behaviour. In fact, many psychologists believe that the
human intellect is actually subservient to human emotion. They contend that human behaviour is less the product
of logic than of subjective impulses such as fear, love, hate, pleasure and pain, and that humans use their intellect
only to achieve or avoid emotional outcomes. Thus, from this perspective, perfect rationality is only a theoretical
construct, not a practical occurrence.

CRITICISMS OF PERFECT SELF-INTEREST

Many studies have demonstrated that human beings are not perfectly self-interested. If they were, neither
philanthropy nor charity would exist. Most religions promote selflessness, sacrifice and kindness and have done
so for centuries. Perfect self-interest would preclude people from performing unselfish acts of kindness such as
volunteering or helping the underprivileged. Perfect self-interest would also prohibit self-destructive behaviour
such as suicide, alcoholism and substance abuse. Again, the argument that people are perfectly self-interested is a
losing one.

CRITICISMS OF PERFECT INFORMATION

Some people may possess perfect or near-perfect information on certain subjects. For example, a doctor or dentist
should be well versed in the inner workings of the human body and mouth. It is not possible, however, for every
person to enjoy perfect knowledge of every subject in existence. For example, suppose a shopper named Mrs.
Rebeiro needs a loaf of bread. If Mrs. Rebeiro had perfect information, she would know the price of every loaf of
bread for sale in every shop in town. But perfect information does not exist in the real world. Many other good
examples can be found in the world of investing, in which there is nearly an infinite amount to know and learn, and
even the most successful investors don’t master all disciplines. One would be hard-pressed to believe that anyone
possesses perfect information, especially in the investing realm.
In conclusion, people are neither perfectly rational nor perfectly irrational, but possess diverse combinations of
rational and irrational characteristics, and can benefit from an advisor’s help with respect to their shortcomings.
With this basis for acknowledging the existence of behavioural finance, it is time to explore another core concept in
behavioural finance: the standard finance versus behavioural finance debate.

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 CHAPTER 2 | UNDERSTANDING A CLIENT’S RISK TOLERANCE 2 •5

STANDARD FINANCE VERSUS BEHAVIOURAL FINANCE

Meir Statman is one of the great contributors to the field of behavioural finance. For Statman, the foundations of
standard finance were built by several important intellectual leaders of finance: the Miller and Modigliani arbitrage
pricing principles, the Markowitz portfolio principles, Sharpe’s capital asset pricing model, and the Black, Scholes,
and Merton option pricing theory. These intellectual leaders of finance provide mathematical explanations for
complex finance questions that, when posed in the real world, are complicated by imprecise and challenging
conditions. The standard finance approach relies on a set of assumptions that often oversimplify reality. For
example, embedded within standard finance is the concept already introduced of Homo economicus, or the rational
economic human being; nice in theory but impractical in reality.
Standard finance is characterized by rules about how investors should behave rather than by principles describing
how they actually behave. Behavioural finance, on the other hand, identifies with and learns from human behaviour
demonstrated by individual investors in financial markets. Behavioural finance, like standard finance, contains
underlying assumptions, but standard finance grounds its assumptions in idealized financial behaviour; behavioural
finance, in observed financial behaviour.

EFFICIENT MARKETS VERSUS IRRATIONAL MARKETS

The efficient market hypothesis was developed from the doctoral dissertation of Professor Eugene Fama of the
University of Chicago. Fama believed and demonstrated that, in a securities market populated by many well-
informed investors, investments will be accurately priced and reflect all available information.1 There are three
forms of the efficient market hypothesis:

Weak form All past market prices and data are fully reflected in current securities prices; that is,
technical analysis is of little or no value.

Semi-strong form All publicly available information is fully reflected in current securities prices; that is,
fundamental analysis and technical analysis are of no value.

Strong form All information (including insider information) is fully reflected in current securities
prices.

Many market efficiency studies point to evidence that supports the efficient market hypothesis. Researchers have
documented numerous, persistent anomalies, however, that contradict the efficient market hypothesis. There are
three main types of market anomalies that advisors should know about:
• Fundamental anomalies
• Technical anomalies
• Calendar anomalies

A fundamental anomaly is an irregularity in a security’s current price when compared to a fundamental

assessment of its intrinsic value. There is a large body of evidence documenting, for example, that investors
consistently overestimate the prospects of growth companies and underestimate the value of out-of-favour
companies. In a totally efficient market, this would not happen. Professors Ken French and Eugene Fama performed
a study of low price-to-book-value ratios that covered a period of 38 years.2 The study considered all equities listed
on NYSE, AMEX, and/or NASDAQ in the United States. The stocks were divided into 10 groups by book/market and
were re-ranked annually.

1
Fama, Eugene F. “Random Walks in Stock-Market Prices.” Selected Papers; No. 16; Chicago Graduate School of Business: University of
Chicago, 1965.
2
Fama, Eugene, and French, Ken. “The Cross-Section of Expected Stock Returns.” Journal of Finance (1992). Winner of the Smith-Breeden prize
for the best paper in the Journal of Finance in 1992.

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The highest book/market stocks outperformed the lowest book/market stocks 21.4% to 8%, with each decile
(representing one-tenth of the sample or population) performing more poorly than the previously ranked, higher-
ratio decile. They also ranked the deciles by beta (the measure of an investment’s volatility relative to the market
as a whole) and found that the value stocks posed lower risk and the growth stocks had the highest risk. This result
encouraged many investors to buy value stocks. The methodology contained in the analysis is widely used today
and is based on inefficient market conditions.
A technical anomaly is rooted in a form of market examination called technical analysis. Technical analysis
attempts to forecast securities prices by studying past prices. Sometimes, technical analysis reveals inconsistencies
with respect to the efficient market hypothesis. Patterns emerge that are called technical anomalies. In general, the
majority of research-focused technical analysis trading methods are based on the principles of the weak-form of the
efficient market hypothesis. Many believe that prices adjust rapidly in response to new stock market information
and that technical analysis techniques are not likely to provide any advantage to investors. However, proponents
continue to argue the validity of certain technical strategies and use them frequently.
A calendar anomaly is an irregular securities pattern that emerges during certain times of the year, such as the
January Effect mentioned earlier. The January Effect shows that stocks in general, and small stocks in particular,
move abnormally higher during the month of January. Haugen and Jorion, two researchers in this area, have
observed that the January Effect is, perhaps, the best-known worldwide example of anomalous behaviour in security
markets.
The January Effect is particularly illuminating because it hasn’t disappeared despite being well known for many
years; arbitrage theory (taking advantage of a state of imbalance between two or more markets) tells us that
anomalies should disappear as traders attempt to exploit them. From a practical standpoint, the January Effect is
attributed to stocks rebounding following year-end tax-loss selling. Individual stocks depressed near year-end are
more likely to be sold for tax reasons.

WHAT IS THE RELEVANCE OF BEHAVIOURAL FINANCE TO

THE INVESTMENT ADVISOR?
The primary purpose of this section is to demonstrate how the investment advisor may leverage behavioural finance
to improve the advisor-client relationship and help clients make better investment decisions. Some advisors may
view behavioural finance as a “new” concept and be reluctant to accept its validity. In fact, irrational behaviour has
been around for centuries, and it should be acknowledged freely. Other advisors may not feel comfortable asking
their clients psychological or behavioural questions in an attempt to learn their biases, especially at the beginning
of the advisory relationship. However, in the coming years, behavioural finance will become a mainstream aspect of
the investment management relationship, for both advisors and clients.
Certainly, if the investment advisor understands how investor psychology can affect an individual investor’s
decisions and consequently her investment outcomes, he will have an insight that can only benefit the advisory
relationship. A key result of a behavioural finance–enhanced relationship will be a portfolio that the client can live
with during up markets and down markets. Clients who understand their own investing behaviour – learned through
working with their investment advisors – will develop stronger relationships with their advisors.
Here is an example of how knowledge of investor psychology can help in the advisor-client relationship. During
the late 1990s, many clients did not stick to asset allocation principles and concentrated their investments in
technology stocks. Knowledgeable advisors counselled their clients to rebalance their accounts by selling large-
cap growth stocks and reinvesting in value stocks. Those who offered this advice and whose clients followed it saw
successful outcomes, and gained the confidence of their clients.

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 CHAPTER 2 | UNDERSTANDING A CLIENT’S RISK TOLERANCE 2 •7

Different advisors have different ways of measuring the success of an advisory relationship. As the next section
will describe in more detail, besides the monetary aspects, successful relationships share at least four fundamental
characteristics:
• The advisor clearly understands the client’s financial goals.
• The advisor uses a structured, consistent approach to advising the client.
• The advisor delivers what the client expects.
• Both the client and the advisor benefit from the relationship.

So, how can behavioural finance lead to a successful advisory relationship?

UNDERSTANDING A CLIENT’S FINANCIAL GOALS

The foundation of a successful advisor-client relationship is the clear definition of the client’s financial goals. The
advisor also needs to know the client’s risk tolerance, return objectives, tax situation and other technical aspects
of his financial situation. It is helpful for the advisor to understand the psychology and emotions underlying the
decisions behind the client’s specified goals. At times, the investment advisor may find herself in the role of a
psychologist – assessing what her client’s motives are when he makes financial decisions. In some cases, she may
need to “save” her client from his own poor decision-making. Naturally, the better the advisor knows her client, the
easier it is for her to psychologically assess him.
Once the investment advisor understands her client’s financial objectives, she can help him make better investment
decisions through considering the remaining three fundamental characteristics of a successful advisory relationship.

MAINTAINING A CONSISTENT APPROACH

Most successful advisors provide a consistent approach to delivering investment management services. Successful
investing is a process, not a monthly or quarterly guess as to what investment will be in vogue, and incorporating
the principles of behavioural finance into the advisory relationship should become part of that disciplined process.
Clients need regular feedback from their advisors on their investment behaviour. A meeting (held quarterly or
semi-annually) could involve a review of not only investment results, but also investment decisions that were
recommended by the advisor and made by the client. With such a review, the advisor gains a knowledge base of
behavioural finance for his future reference.
Once a foundation of knowledge in behavioural techniques is gained, the advisor will be able to consistently assess
his clients’ behaviour, which will add more professionalism and structure to those relationships. Most clients
appreciate their advisors’ efforts in getting to know them better, and these relationships will, more than likely, be
more successful.

WHAT THE CLIENT EXPECTS

A client expects two main things from his advisor:
1. An understanding of the client’s objectives based on a needs assessment
2. Investment returns that are consistent with those objectives (and other aspects such as risk tolerance)

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There is perhaps no other aspect of the advisory relationship that could benefit more from behavioural finance than
delivering what the client expects. Advisors who can incorporate behavioural finance into meeting these two key
expectations will benefit enormously. For example, many clients overestimate their risk-return profile. Advisors who
can identify behavioural issues – such as bringing into focus a client’s actual risk tolerance – before they become a
problem will be able to deliver on client expectations consistently. In many instances, the advisor does not make an
attempt to understand the behaviour that drives the client’s investment decision-making, and therefore fails to help
the client reach his objectives.

ENSURING MUTUAL BENEFITS

Any measures taken that result in happier, more satisfied clients strengthen the advisor’s practice and enhance the
advisor’s work life. A client who is happy and satisfied will have financial security and confidence and have no reason
to seek the services of a competing advisor. When both the client and the advisor benefit, a strong relationship
usually results. Incorporating insights from behavioural finance into the advisory relationship enhances it and leads
to more fruitful results for both client and advisor.
Average or even slightly below average investment results are often not the primary reason that a client seeks a
new advisor (although extremely poor returns are cause for major concern). The number one reason that an advisor
loses a client is that the client does not feel as though his advisor understands, or attempts to understand, his
financial objectives – and the inevitable result is a poor relationship. The primary benefit that the understanding
and application of behavioural finance offer is the strengthening of the bond between client and advisor, not only
at the beginning of the relationship but as it develops. By getting “inside the head” of the client and developing a
comprehensive grasp of her motivations and fears, the advisor can help the client better understand why a portfolio
is designed the way it is, and why it is the “right” portfolio for her – regardless of what happens day to day in the
markets.
Behavioural finance stresses the importance of understanding the biases and psychological attitudes of the
individual investor. One way standard finance has measured clients’ risk tolerance or aversion is through the use of
risk tolerance questionnaires. As the following section outlines, the traditional questionnaire’s place in the advisory
relationship is subject to some limitations.

WHAT ARE RISK TOLERANCE QUESTIONNAIRES AND

THEIR LIMITATIONS?
The advisor’s pursuit in understanding a client’s investment psychology has to begin with a pointed and purposeful
conversation about risk. Questionnaires do provide some useful information but cannot be relied upon for a full
picture of client risk tolerance. Many financial firms, in an attempt to standardize asset allocation processes,
do require their advisors to administer risk tolerance questionnaires to clients prior to making investment
recommendations. Some typical questions are illustrated in the following examples.

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 CHAPTER 2 | UNDERSTANDING A CLIENT’S RISK TOLERANCE 2 •9

Sample Risk Tolerance Questionnaire

1. What is your primary investment objective?

a. Aggressive growth of capital
b. Growth of capital
c. Growth and income
d. Income
e. Preservation of capital

2. What do you consider to be your investment horizon?

a. Less than 1 year
b. 1–2 years
c. 2–5 years
d. 5–10 years
e. Longer than 10 years

3. Which of the following best fits you when you consider the risks and returns involved in investing?
a. Portfolio returns are the most important factor; risk is not really a factor.
b. Returns and risk should be balanced.
c. Risk is the most important factor.

4. If historical returns approximate 11% for large-cap stocks, 12.5% for small-cap stocks, 5% for Government
bonds, 3.5% for T-Bills and inflation of 2.5% then based on this information, what do you expect as a return on
your investment portfolio?
a. 0%–5%
b. 5%–10%
c. 10%–15%
d. Greater than 15%

5. At what point would you consider selling a losing investment?

a. A loss of 5%–10%
b. A loss of 10%–15%
c. A loss of 15%–20%
d. A loss of 20%–30%
e. I don’t sell even at a substantial loss.

From the behavioural finance perspective, risk tolerance questionnaires may work well for institutional investors but
often fail psychologically biased individuals. A prime example of a failure to assess properly an individual investor’s
risk tolerance is the scenario in which a client demands, in response to short-term market fluctuations, that his
asset allocation be changed. Moving repeatedly in and out of an allocation can cause serious, long-term negative
consequences to a portfolio. Panic selling is often treated as a buying opportunity by behaviourally aware investors.
Behavioural biases need to be identified before the allocation is executed, so that such problems can be avoided.
Advisors may feel the need to remind clients not to sell during down periods, and to hold on to winners during up
periods. Many clients have an innate desire to hold on to losing investments and to sell winners too quickly.

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In addition to ignoring behavioural issues, risk tolerance questionnaires can generate different results when
administered in slightly varying formats to the same individual investor. The differences are usually a result of
variations in how questions are worded. Also, most risk tolerance questionnaires are administered once, at the
beginning of the advisory relationship, and are never revisited. Since risk tolerances change throughout a person’s
life, advisors need to update their files to keep risk tolerance information current.
Another critical issue with respect to risk tolerance questionnaires is that many advisors interpret the results too
literally. For instance, a client might indicate the maximum loss she would be willing to tolerate in a single year
would be 20% of her total assets. Does that mean that an ideal portfolio would place such a client in a position
to lose 20%? No. Advisors should set portfolio parameters that preclude a client incurring the maximum specified
tolerable loss in any given period. For these reasons, risk tolerance questionnaires only provide guidelines for asset
allocation, and should be used in concert with behavioural assessment tools.
Another reason why risk tolerance questionnaires may yield information of limited usefulness is because of the
framing bias sometimes inherent in the design of the questions. Ideally, question-phrasing should not affect the
questionnaire’s results. However, it can happen, as the following example illustrates.

EXAMPLE
Framing Bias and Risk Tolerance Questionnaires
Suppose an investor completes a risk tolerance questionnaire for the purpose of determining the “risk category”
into which he belongs. Suppose that the questionnaire refers to a hypothetical securities fund called Fund A. Over
a 10-year period, this Fund has returned an annual average of 12%, with a standard deviation of 15%. Standard
deviation quantifies the amount of expected variation in an investment’s performance from year to year based
on historical data. The expectation is that 67% of A’s returns will fall within one standard deviation of the mean,
or annual average return of 12%. Similarly, 95% of returns will fall within two standard deviations, and 99.7%
within three standard deviations of the mean. So, if A’s mean return was 12%, and its standard deviation was
15%, then two-thirds of all returns produced by A would equal 12% plus or minus 15% – that is, 67% of the time,
it is expected that Fund A will return somewhere between -3% to 27%. It follows that 95% of A’s returns will fall
between -18% and 42%, and 99.7% will fall somewhere between -33% and 57%.
Now, imagine that one, but not both, of the following questions is to appear on an investor’s risk tolerance
questionnaire. Both concern Fund A, and both try to measure an investor’s comfort level with A, given its average
returns, volatility and so on. However, the two questions frame the situation differently. Considering Question 1
and Question 2, how might a client subject to a few common behavioural biases respond to each question?
Would the client’s answers be identical in each instance?

Question 1:
Based on the chart below, which investment fund seems like the best fit for you based on your risk tolerance and
your desire for long-term return?

Portfolio Name 95% Probability Gain/Loss Range Long-Term Return

B 3% to 5% 4%
C -7% to 17% 7%
A -18% to 42% 12%

a. Fund B
b. Fund C
c. Fund A

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EXAMPLE
Cont'd

Now consider Question 2. Ignore Question 1 above while doing so.

Question 2:
Let us assume you are contemplating investing money in Fund A. Based on the Fund’s past performance, the
managers of Fund A expect that two-thirds of the time Fund A will earn between 27% and -3%. They also believe
that there is a small chance that it might earn less than -3% in some years. Will you invest in A?
a. Yes, I will invest in A, because I am comfortable with the risk level.
b. I might invest in A, but I want to know more about the risk level.
c. No, I won’t invest in A, because I don’t want such a wide range of returns.

When describing risk, many advisors use one standard deviation as the measure of risk. Many do not explain
two or three standard deviations. There is a chance that a client will select similar answers for both questions.
However, there is also a good chance that many investors would answer these two questions differently.
Specifically, respondents might reject Fund A in Question 1, yet when faced with Question 2, might decide to
proceed with A. In Question 1, “95% Probability Gain/Loss Range” refers to two standard deviations above and
below the mean. In Question 2, the reader contemplates a return of one standard deviation. Because Question 2
employs one standard deviation rather than two, readers are less likely to consider the one-third of all cases in
which A could lose more than 5% of its value (entering into the 95%, rather than the 67%, probability gain/loss
range). Here, the implications of framing are important: inconsistent responses to the questions above could
make the questionnaire ineffective and an inaccurate measure of investor risk tolerance. So, advisors need to be
aware of how framing can affect the outcome of various investment choices.

WHAT ARE INVESTOR BIASES?

To effectively establish the nature and priorities of an investor’s hierarchy of needs, the investment advisor must be
cognisant of investor biases.
A bias can be described as a preference or an inclination (especially one that inhibits impartial judgement) or an
unfair act or policy stemming from prejudice.3 In the investment realm, behavioural biases are defined as systematic
errors in financial judgement or imperfections in the perception of economic reality. Over the past 25 years or so,
researchers have identified a long list of investor biases, categorizing them according to a meaningful framework.
Some refer to biases as heuristics (simple, efficient rules of thumb); others call them beliefs, judgements or
preferences; still others classify biases along cognitive or emotional lines. In working with clients, the advisor need
not classify or categorize his clients’ biases. However, he does need to understand the concepts and be able to apply
them to client situations.
For the moment, it’s not important to make an elaborate distinction between types of biases, but enough simply to
note whether a particular bias is cognitive or emotional. Later, it will be clear why it is useful to distinguish biases in
this way.

3
The American Heritage Dictionary of the English Language, Fifth Edition. Copyright 2015 by Houghton Mifflin Harcourt Publishing Company.

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DIFFERENCES BETWEEN COGNITIVE AND EMOTIONAL BIASES

Behavioural biases fall into two broad categories, cognitive and emotional, with both yielding irrational judgements.
A cognitive bias can be technically defined as basic statistical, information processing or memory errors that are
common to all human beings. They can be thought of also as “blind spots” or distortions in the human mind. One of
the most common cognitive biases is anchoring bias. Here, clients get anchored to the price of a stock or the level of
the market and hold on to that price before being willing or able to make an investment decision. Cognitive biases
were first identified by Amos Tversky and Daniel Kahneman as a foundation of behavioural economics. Tversky and
Kahneman argue that cognitive biases are used in problem-solving through heuristics that include the availability
heuristic and the representativeness heuristic.4
Cognitive biases do not result from emotional or intellectual predisposition toward a certain judgement, but rather
from subconscious mental procedures for processing information.
Investors are subjected to large volumes of information and data, and to make sense of it all, they opt for simplified
information processing when making investment decisions. A good example of this is evaluating a class of mutual
funds, say U.S. small-capitalization. Even using a research service such as Morningstar, which helps clients screen
funds, the information flow is so immense that they inevitably rely on shortcuts such as “best 12-month return”
to make a fund choice. Because cognitive biases stem from faulty reasoning, better information and advice
can often correct them. Cognitive biases include heuristics, such as anchoring and adjustment, availability and
representativeness biases. Other cognitive biases include ambiguity aversion, self-attribution and conservatism.
On the opposite side of the spectrum from illogical or distorted reasoning are the emotional biases. An emotion is
a mental state that arises spontaneously, rather than through conscious effort. Emotions are physical expressions,
often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in
reality or in the imagination.
Emotions can be undesired to the individual feeling them; she may wish to control them but often cannot. Investors
can be presented with investment choices, and may make sub-optimal decisions by having emotions affect
these decisions. Often, because emotional biases originate from impulse or intuition rather than from conscious
calculations, they are difficult to correct. Emotional biases include endowment, loss aversion and self-control.

OVERVIEW OF BEHAVIOURAL BIASES

An overview of 20 common biases is presented below. Fourteen of these are cognitive biases, and six are emotional
biases.

COGNITIVE BIASES
1. OVERCONFIDENCE
Overconfidence is defined generally as unwarranted faith in one’s intuitive reasoning, judgements and cognitive
abilities. People tend to overestimate both their predictive abilities as well as the precision of the information they
have been given. Sometimes, people realize that events they thought were certain to happen did not occur, but they
don’t learn from these mistakes. In the investing realm, people think they are smarter and have better information
than they actually do. For example, an investor may get a tip from an investment advisor or read something on the
Internet about an investment opportunity, and then take action (that is, make the decision to invest) based on her
perceived knowledge advantage.

4
Kahneman, D., and Tversky, A. “Prospect theory: An analysis of decisions under risk.” Econometrica, 1979.

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2. REPRESENTATIVENESS
Because human beings like to stay organized, they develop, over time, an internal system for classifying objects and
thoughts. When confronted with new circumstances that may be inconsistent with existing classifications, they
often rely on a “best fit” process to determine which category should house and form the basis for understanding
the new circumstance. This perceptual framework provides a practical tool for processing new information by
simultaneously incorporating insights gained from past experiences. Sometimes, however, new stimuli are
representative of elements that have already been classified, while in reality, there are differences. In such an
instance, the classification reflex is wrong, and it produces an incorrect understanding of the new element that
often persists and biases future interactions with that element.
In the investment realm, a client may be presented with an investment opportunity that contains some elements
representative of a good investment. The client’s desire to mentally classify the investment opportunity may
cause him to classify what is really a poor investment opportunity as a good investment opportunity, based on the
few elements that are representative of a good investment opportunity. Initial public offerings (IPOs) are a good
example of this concept.

3. ANCHORING AND ADJUSTMENT

If a person is asked to estimate a value in an area that they have little or no familiarity with, such as the distance to
the moon, and are presented with an initial, default number – an anchor – then they typically adjust up or down to
reflect subsequent information and analysis. The anchor, once fine-tuned and re-assessed, can sometimes mature
into a final estimate. People are generally better at estimating relative comparisons rather than absolute figures.
The following example illustrates how this works in the investment world. Suppose a client is asked whether the
Dow Jones Industrial Average will be greater or less than 19,000 next year. Obviously, the answer will be either
above 19,000 or below 19,000. If the client were then asked to guess an absolute value of the index next year, the
estimate would probably fall somewhere near 19,000, because it (i.e., the estimate) is likely subject to anchoring by
the previous response.

4. COGNITIVE DISSONANCE
When people are presented with information that conflicts with pre-existing beliefs, they usually experience mental
discomfort, commonly referred to as cognitive dissonance. Cognitions, in psychology, represent attitudes, emotions,
beliefs or values. Cognitive dissonance is a state of mental imbalance that occurs when contradictory cognitions
bump into one another. The term encompasses the response that arises as people struggle to relieve their mental
discomfort by trying to get conflicting cognitions to align. For example, an investor might invest in stock ABC,
initially believing that it is the best stock available. However, when a new cognition that favours a substitute stock
is presented, an imbalance occurs. Cognitive dissonance takes over in an attempt to relieve the discomfort with
the notion that perhaps the investor did not purchase the best stock. People will go to great lengths to convince
themselves they made the right decision, to avoid mental discomfort associated with their initial investment.

5. AVAILABILITY
The availability bias is a heuristic that allows people to estimate the probability of an outcome based on how
prevalent or familiar that outcome appears in their lives. People exhibiting availability bias perceive easily recalled
possibilities as being more likely than outcomes that are harder to imagine or difficult to comprehend. One classic
example cites the tendency of most people to guess that shark attacks cause fatalities more frequently than
injuries sustained from falling airplane parts. However, the latter has been shown to be thirty times more likely to
occur. Shark attacks are, probably, assumed to be more prevalent because sharks invoke greater fear, or because
shark attacks receive a disproportionate degree of media attention. Mutual fund advertising is a good example of
availability bias. Investors who see a certain company’s advertisements frequently may believe that that company is
a good mutual fund company, when it’s possible that a company that does no advertising is better.

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6. SELF-ATTRIBUTION
Self-attribution bias (also known as self-serving bias) is the tendency of individuals to ascribe their successes to
personal traits, such as talent or foresight, and to blame failure on outside influences, such as bad luck. Students
doing well on an exam, for example, might credit their own intelligence or work ethic, while those failing might cite
unfair grading. Investors often incorrectly ascribe investment success to themselves, while investment failure is
usually someone else’s fault.

7. ILLUSION OF CONTROL
Illusion of control bias is the tendency of individuals to believe that they can control random outcomes when, in
reality, they cannot. This bias is often observed in casinos. Some casino patrons swear that they are able to influence
a roll of the dice by blowing on them. In the casino game of craps, for example, research has demonstrated that
people actually cast the dice more vigorously when they are trying to attain a higher number. Extrapolating this idea
to investments, some people think that they can control the outcome of an investment they make; naturally, this is
pure fantasy (unless, of course, the person is a CEO or in an actual control position).

8. CONSERVATISM
Conservatism bias is a mental state in which people cling to a prior view or forecast and do not acknowledge
or obtain new information that might change an existing view. For example, say an investor receives bad news
regarding a company’s earnings and this news contradicts an earnings estimate issued in the previous month.
Conservatism bias may cause the investor to under-react to the new information, maintaining a belief in the
previous, more optimistic estimate, rather than to act on the updated information.

9. AMBIGUITY AVERSION
People avoid making an investment or taking risks when probability distributions seem uncertain to them, because
they hesitate in situations of ambiguity. This tendency is referred to as ambiguity aversion. It appears in a wide
variety of contexts, especially with investing. Older clients may be more prone to ambiguity aversion.

10. MENTAL ACCOUNTING

First identified by University of Chicago professor Richard Thaler, mental accounting describes people’s tendency to
categorize and evaluate economic outcomes by grouping assets into non-fungible (non-interchangeable) mental
accounts.5 Mental accounting causes investors to irrationally treat various sums of money differently based on
where these sums are mentally categorized. The way that money is obtained (work, inheritance, gambling, bonus,
and so on) or the nature of the money’s intended use (for example, leisure or necessities) can affect how that
money is treated.
For example, Thaler performed an experiment in which he offered one group of people $30 and this choice: keep the
$30 or gamble on a coin toss. A correct toss would add $9 and an incorrect toss would subtract $9 from the initial
$30 gift. The majority of subjects offered this choice, 70%, elected to gamble, because they considered the $30 to
be “found” money. A second group of subjects was offered a slightly different choice. They were asked: would you
rather gamble on a coin toss, in which you will receive $39 for a win and $21 for a loss, or would you rather simply
pocket $30 and forgo the coin toss? The key difference is that the second group was not immediately given $30.
The second group reacted differently from the first. Only 34% of them chose to gamble, even though the economic
prospects they faced were identical to those offered group one. In this case, the first group put the amount in the
“found money” account and, therefore, was willing to risk it. The second group had not yet “found” the money and
was, therefore, less willing to risk it.

5
Thaler, R. H. “Towards a positive theory of consumer choice.” Journal of Economic Behavior and Organization, 1, 1980, 39–60

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11. CONFIRMATION
Confirmation bias is a type of selective perception in which people emphasize ideas that confirm their beliefs, and
discount ideas that contradict their beliefs. For example, a person may believe that people wear more red shirts
during the summer than during any other time of the year; however, this position may be due to confirmation bias,
which causes that person simply to notice more red shirts during the summer because he wears red during the
summer, while overlooking shirt colours during other months. This tendency, over time, unjustifiably strengthens
the belief regarding the summertime concentration of red shirts. Investors may confirm things about a security they
want to confirm, such as good earnings, but may overlook negative factors affecting the outcome of an investment.

12. HINDSIGHT
After the outcome of an event is known, some people believe that the outcome was predictable – even if it was
not. This happens because actual outcomes are clear in a person’s mind but the myriad outcomes that could have
occurred but did not are rather fuzzy. Therefore, people tend to overestimate the accuracy of their own predictions.
Hindsight bias has been demonstrated repeatedly by investors: a stock goes up and an investor feels he “knew it all
along,” but in fact the outcome was unpredictable.

13. RECENCY
Recency bias causes people to recall and emphasize recent events more prominently than those that occurred in the
near or distant past. For example, recency bias can cause investors to ignore fundamental value and focus only on
recent upward price performance. When a return cycle peaks and recent performance figures are most attractive,
it is human nature to chase the promise of a profit. Asset classes become overvalued, and by focusing only on price
performance and not on valuation, investors risk principal loss when these investments revert to their mean or long-
term averages.

14. FRAMING
Framing bias is the tendency to respond to various situations differently, based on the context in which a choice
is presented (or framed). Everyday evidence of framing bias can be found at the grocery store. Many grocers will
price items in multiples – for example, “2 for $2” or “3 for $10”. The pricing doesn’t necessarily imply that any kind
of bulk discount is being offered. An item priced at “3 for $10” could also be available at a unit price of $3.33. The
optimistic or pessimistic manner in which an investment or asset allocation recommendation is framed can affect
people’s willingness to invest. Optimistically worded questions are more likely to be acted upon than negatively
worded ones, and optimistically worded answer choices are more likely to be selected than pessimistically phrased
alternatives. Framing contexts are often arbitrary and uncorrelated and, therefore, should not impact investors’
judgements. But often, they do.

EMOTIONAL BIASES
15. ENDOWMENT
People who are subject to endowment bias place more value on an asset they hold property rights to than on an
asset they do not hold property rights to. This behaviour is inconsistent with standard economic theory, which says
that a person’s willingness to pay for a good or object should be equal to the person’s willingness to sell the good or
object. Psychologists have found that the minimum selling prices that people state tend to exceed the maximum
purchase prices they are willing to pay for the same good. Investors continue to hold securities they own rather than
disposing of them in favour of better investing opportunities.

16. SELF-CONTROL
Self-control bias (really, a lack of self-control) is the tendency to consume today at the expense of saving for
tomorrow. Money is an area in which people often lack self-control. Behaviour displayed while paying taxes
provides a common example. Imagine that a taxpayer knows for certain that he must pay exactly $7,200 in income

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taxes one year from now. So, which of the following choices seems ideal: would the taxpayer rather contribute
$600 per month, over the course of the next year, to a savings account earmarked for tax season? Or would he
rather increase income tax withholding by $600 each month, thus avoiding the responsibility of writing out one
large cheque at the end of the year? Rational economic thinking suggests that the taxpayer would prefer the savings
account approach since the money would accrue interest and would actually be more than $7,200 at the end of the
year. However, many taxpayers choose the withholding option, because they realize that the savings account plan
could be complicated in practice due to a lack of self-control.

17. OPTIMISM
Empirical studies have demonstrated that with respect to almost any personal trait perceived as positive – good
looks, sense of humour, attractive physique, expected longevity and so on – most people tend to rate themselves
as surpassing the population mean (the average of all items in a population). This tendency is known as optimism
bias. Investors, too, tend to be overly optimistic about the markets, the economy and the potential for positive
performance of their investments. Many overly optimistic investors believe that bad investment outcomes will not
happen to them but only to other people. However, everyone makes bad investment decisions, even the legendary
Warren Buffett (one of the richest people in the world).

18. LOSS AVERSION

Loss aversion bias was developed as a concept by Daniel Kahneman and Amos Tversky in response to the
observation that people generally feel a stronger impulse to avoid losses than to acquire gains.6 The possibility of a
loss is, on average, twice as powerful a motivator as the possibility of making a gain of equal magnitude. That is, a
loss-averse person might demand, at minimum, a two-dollar gain for every one dollar placed at risk. In this scenario,
risks that don’t “pay double” are unacceptable. Loss aversion can prevent people from unloading unprofitable
investments, even when they see little to no prospect of a turnaround. Some industry veterans have coined a
diagnosis, “get-even-itis”, to describe this condition whereby a person waits too long for an investment to rebound
following a loss.

19. REGRET AVERSION

People who are subject to regret aversion bias avoid making decisions because they fear, in hindsight, that whatever
they decide to do will result in a bad decision. An example of regret aversion is observed when investors hold on to
losing positions too long in order to avoid admitting errors and realizing losses. When investors experience negative
investment outcomes, they feel instinctually driven to sell – not to press on and snap up potentially undervalued
stocks. However, periods of depressed prices often present the greatest buying opportunities. People suffering from
regret aversion bias, therefore, hesitate most at moments that actually may merit aggressive behaviour.

20. STATUS QUO

Status quo bias is an emotional bias that predisposes people, when faced with a wide variety of options, to choose
to keep things the same (that is, to maintain the status quo). The scientific principle of inertia, which states that
a body at rest shall remain at rest unless acted upon by an outside force, is a similar concept. Status quo bias can
cause investors to hold securities with which they feel familiar or emotionally fond. This behaviour can compromise
financial goals, however, because a subjective comfort level with a security may not justify holding onto it despite
poor performance.

IDENTIFYING BEHAVIOURAL BIASES IN CLIENTS

Some advisors are naturally good at identifying irrational behaviours in their clients. Others need some assistance.
A diagnostic test for loss aversion, below, provides an understanding of how a bias is diagnosed.

6
Kahneman and Tversky, 1979.

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Question 1: You are asked to choose between the following two outcomes:
a. An assured gain of $475
b. A 25% chance of gaining $2,000, and a 75% chance of gaining nothing

Question 2: You are asked to choose between the following two outcomes:
a. An assured loss of $750
b. A 75% chance of losing $1,000, and a 25% chance of losing nothing

How is the loss-averse client likely to respond?

Scoring Guideline
Question 1: The rational response is b, but loss-averse investors are likely to opt for the assurance of a gain in a.
Question 2: The rational response is a. Loss-averse investors are more likely to select b.
The logical question at this point from advisors is: “Fine, so I know what biases my client has...what do I do with this
knowledge?” By the end of this chapter, this question will be dealt with, in a discussion on how the advisor goes
about creating a behaviourally adjusted portfolio, one that moderates or adapts to a client’s biases. First, though,
consider the equally intriguing question below of gender differences that may affect an investor’s decision-making
behaviour.

GENDER AND BEHAVIOURAL FINANCE

Gender and behavioural finance is a potent subject. Men and women behave quite differently when it comes to
investing, and it is important to understand and remember these differences. This section reviews some pertinent
studies on the link between gender and behavioural finance biases, and then offers some conclusions about how
certain biases apply to women and men.
Perhaps the most prominent and comprehensive gender-focused study was completed by Barber and Odean,
entitled “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment”.7 The study concludes that
men are more subject than women to the overconfidence bias as reflected in trading behaviour. These researchers
found, by examining investment transactions of 35,000 households over a 7-year period, that men on average
traded 45.0% more than women. And single men on average traded 67.0% more than single women. When it came
to returns, Barber and Odean found similar results. Women underperformed a buy-and-hold approach by about
1.0% on average. Men underperformed by 1.4%, and single men by 2.0% on average. It appears that women in a
household reduce the risk-taking of the family and have more patience than men in investing activities.
With regard to gender differences:
• Women believe that random sequences with no automatic correlation display positive correlation in reality.
For example, many basketball coaches and players believe that a player who has made several shots in a row is
more likely than usual to make the next shot; that is, they see patterns where perhaps none exist.
• Men are more overconfident and optimistic than women.
• Women are more likely to buy and hold.
• Men are one-third more risk tolerant than women.

7
Barber, B. and Odean, T. “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” Quarterly Journal of Economics, Vol.
116, No. 1, 2001, 261–292.

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Some studies concluded that women are less optimistic or more skeptical than men, and they are also generally
less risk tolerant than men. Alexandra Niessen and Stephan Ruenzi from the University of Cologne completed a
study entitled “Gender and Mutual Funds”8 in which they examined all single managed U.S. equity mutual funds
over a 10-year period. In the study, 10% of fund managers were women. They found that female managers take less
risk, follow less extreme investment styles (i.e., execute more consistent styles), are less overconfident and trade
less. Women who are less risk tolerant and trade less tend to balance out men who tend to be aggressive in these
areas. Investment advisors should listen to both the male and the female partner, and attempt to arrive at a risk
assessment that reflects a balance between them.
Merrill Lynch Investment Managers completed a study entitled “When It Comes to Investing, Gender Is a Strong
Influence on Behavior”9 in which they surveyed 500 male and 500 female clients for their attitudes, beliefs and
knowledge levels on investing. They found that:
• Women are less likely to hold losing investments too long (35% vs. 47%).
• Women are less likely to sell a winning investment too quickly (28% vs. 43%).
• Men are more likely to allocate too much money to one investment (32% vs. 23%).
• Men are more likely to buy a hot investment without doing research (24% vs. 13%).
• Men are more likely to trade too much (12% vs. 5%).

Figure 2.1 provides a summary of major male and female biases. Generally, men are more susceptible to cognitive
biases and women are more susceptible to emotional biases.

Figure 2.1 | Typical Biases Men and Women Are Susceptible to

Men are susceptible to: Women are susceptible to:

Overconfidence bias (Cognitive) Endowment bias (Emotional)
Loss aversion bias (E) Status quo bias (E)
Availability bias (C) Representativeness bias (C)
Cognitive dissonance bias (C) Regret aversion bias (E)

WHAT ARE INVESTOR PERSONALITY TYPES?

Some large financial firms have conducted studies that classified people as reluctant investors, competitive investors,
analytical investors and so on. Individual advisors, academics and other researchers have made some interesting
correlations between psychological traits and financial behaviour: for example, some personality types have little
time or patience for managing money, some start investing too late and some show more discipline than others.

EIGHT INVESTOR PERSONALITY TYPES (IPTs)

There are three investor personality dimensions:
• Idealism versus Pragmatism (I vs. P)
• Framing versus Integrating (F vs. N)

8
Niessen, A and Ruenzi, S. “Sex Matters: Gender and Mutual Funds.” Department of Finance, University of Cologne, Germany, November 2005.
9
Frank, M. and Bishop, S. “When It Comes to Investing, Gender a Strong Influence on Behavior.” Hindsight to Insight. Merrill Lynch Investment
Managers, April 2005.

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• Reflecting versus Realism (T vs. R)

Figure 2.2 | Offers a Visual Depiction of these Three Continuums

Idealism (I) Pragmatism (P)

Framing (F) Integrating (N)
Reflecting (T) Realism (R)

Combining the elements of these three different dimensions, the eight possible investor personality types are IFT,
IFR, INT, INR, PFT, PFR, PNT and PNR. After a review of each investor personality type dimension, we will go on
to complete a diagnostic test, the results of which will correspond to a particular dimension that is designed to
determine where an investor falls on a specific behavioural scale (e.g., “Are you more idealistic or pragmatic?”).
We will discuss scoring methods for investor personality diagnostics, and summarize important investment
considerations for each of the eight possible types.

IDEALISM VERSUS PRAGMATISM (I VS. P)

People who fall into the “idealist” end of the I vs. P spectrum overestimate their investing abilities, display excessive
optimism about the capital markets and do not seek out information that contradicts their views. For example,
many investors continued buying technology stocks even as they fell during the meltdown in 2000, eternally
optimistic that these stocks would make a comeback. They discern patterns where none exist, and believe that
their above-average market acumen gives them an exaggerated degree of control over the outcomes of their
investments.
Often disinclined to thorough research, they can fall prey to speculative market fads. Idealists can be susceptible
to the following biases: overconfidence, optimism, availability, self-attribution, illusion of control, confirmation,
recency and representativeness. Pragmatists, on the other hand, display a realistic grasp of their own skills and
limitations as investors. They are not too overconfident about the capital markets and demonstrate a healthy
dose of skepticism regarding their investing abilities. They understand that investing is an undertaking based on
probabilities, and do research to confirm their beliefs. Pragmatists are investors who are typically not susceptible to
the aforementioned biases.

FRAMING VERSUS INTEGRATING (F VS. N)

Framers tend to evaluate each of their investments individually and do not consider how each investment fits into
an overall portfolio plan. They are too rigid in their mental approach to analyzing problems. The framer’s portfolio
is composed of unique “pots” of money, rather than a composite of well-managed investments. For example, these
investors typically have different allocations for “retirement money”, “vacation money” and “university savings”.
This is not necessarily a bad thing, but advisors need to watch for overlap among allocation to guard their clients
against over-concentrating in one asset class.
Framers also subconsciously “anchor” their estimates of market or security price levels, clinging to arbitrary
purchase “points”, which leads to bias in future calculations. Integrators, on the other hand, are characterized by
an ability to contemplate broader contexts and externalities. They correctly view their portfolios as systems whose
components can interact and balance one another out. Integrators understand the correlations between various
financial instruments and structure their portfolios accordingly. They are also flexible in their approach to market
and security price levels. Framers may be susceptible to the following biases: anchoring, conservatism, mental
accounting, framing and ambiguity aversion. Integrators are investors who are typically not susceptible to the
aforementioned biases.

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REFLECTING VERSUS REALISM (T VS. R)

Reflectors have difficulty living with the consequences of their decisions and have difficulty taking action to rectify
their behaviours. They justify and rationalize incorrect actions and hesitate to own up to decisions that have not
worked out beneficially. They also suffer from decision paralysis because they dread the sensation of regret should
they miscalculate. An example of this type of behaviour is holding inherited securities – out of a sense of loyalty to
a deceased relative – which may not be a good fit in a diversified portfolio in the current investment environment.
Realists, on the other hand, have less trouble coming to terms with the consequences of their choices. They don’t
tend to scramble for excuses in order to justify incorrect actions, and they assume responsibility for their mistakes.
Realists also have an easier time than reflectors with decision-making under pressure because they don’t experience
regret as acutely and, therefore, don’t dread it ahead of time. Reflectors may be susceptible to the following biases:
cognitive dissonance, loss aversion, endowment, self-control, regret aversion, status quo and hindsight. Realists are
investors who are typically not susceptible to the aforementioned biases.

HOW DO INVESTMENT ADVISORS APPLY BIAS DIAGNOSES WHEN

STRUCTURING ASSET ALLOCATIONS?
Many investment advisors, when designing an asset allocation program for a client, typically first administer a risk
tolerance questionnaire, then discuss the client’s financial goals and constraints, and then recommend the output of
a computer-generated asset allocation. Less-than-optimal outcomes are often a result of this process because the
client’s psychological biases may not be accounted for.
Instead, investors may be better served by moving themselves up or down the efficient frontier (a set of optimal
portfolios), adjusting risk and return levels depending upon their behavioural tendencies. Michael Pompian calls this
a client’s best practical allocation. A best practical allocation may slightly underperform over the long term and have
lower risk, but is an allocation that the client can comfortably adhere to over the long run. Many clients, in response
to a market downturn, want to sell in a panic. Conversely, a client’s best practical allocation might contradict their
natural psychological tendencies, and these clients may be well served to accept risks in excess of their individual
comfort levels in order to maximize expected returns because, for example, they risk outliving their assets. The
ability to create best practical allocations is what investment advisors should gain from this section.
The following has been adapted from an article that Michael Pompian and John Longo originally published in the
March 2005 Journal of Financial Planning. It sets forth two principles for constructing a best practical allocation, in
light of client behavioural biases:
• Moderate biases in less-wealthy clients; adapt to biases in wealthier ones.
• Moderate cognitive biases; adapt to emotional ones.

These principles are not intended as prescriptive absolutes, but rather should be used along with other data on risk
tolerance, financial goals, asset class preferences and so on. The principles are also general enough to fit almost any
client situation.
When considering behavioural biases in asset allocation, investment advisors must first determine whether to
moderate or adapt to “irrational” client preferences. This decision basically involves weighing the rewards of
sustaining a calculated, profit-maximizing allocation against the outcome of potentially affronting the client –
whose biases might position her to favour a different portfolio structure entirely. Here are guidelines for resolving
the puzzle of when to moderate and when to adapt.

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MODERATE BIASES IN LESS-WEALTHY CLIENTS; ADAPT TO BIASES IN WEALTHIER ONES

A client outliving his assets constitutes a far graver investment failure than his inability to accumulate the greatest
possible wealth. If an allocation performs poorly because it conforms, or adapts, too willingly to a client’s biases,
then a less-wealthy client’s standard of living could be seriously jeopardized. The most financially secure clients,
however, would likely continue to reside in the 99.9th socioeconomic percentile. In other words, if a biased
allocation could put a client’s way of life at risk, moderating the bias is the best response. If only a highly unlikely
event such as a market crash could threaten the client’s day-to-day security, then overcoming the potentially
sub-optimal impact of behavioural bias on portfolio returns becomes a lesser consideration. Adapting is, then, the
appropriate course of action.

MODERATE COGNITIVE BIASES; ADAPT TO EMOTIONAL ONES

As already seen, behavioural biases fall into two broad categories, cognitive and emotional, with both yielding
irrational judgements. Because cognitive biases stem from faulty reasoning, better information and advice can
often correct them. On the other hand, because emotional biases originate from impulse or intuition rather than
conscious calculation, they are difficult to rectify. Cognitive biases include heuristics, such as anchoring and
adjustment, availability and representativeness. Other cognitive biases include ambiguity aversion, self-attribution
and conservatism. Emotional biases include endowment, loss aversion and self-control.
In some cases, heeding these two principles simultaneously yields a blended recommendation. For instance, a
less-wealthy client with strong emotional biases should be both adapted to and moderated. Figure 2.3 illustrates
this situation. Additionally, these principles tell us that two clients exhibiting the same biases should sometimes be
advised differently.

Figure 2.3 | A Visual Depiction of Best Practical Allocation

High Level of Wealth

(Adapt)

Moderate & Adapt Adapt

Cognitive Biases Emotional Biases
(Moderate) (Adapt)
Moderate Moderate & Adapt

Low Level of Wealth

(Moderate)

Source: Pompian, M. and Longo, J. “Incorporating Behavioral Finance Into Your Practice.” Journal of Financial Planning, March 2005, 58–63.

Understanding clients’ risk tolerance is extremely important to the success of both the investment advisor and the
client. This chapter has provided much detail about the relatively new field of behavioural finance and its impact on
clients’ investment behaviour and performance. Clients are susceptible to numerous behavioural biases, and 20 of
the most common ones have been described. Advisors have also been provided with a template showing how they
can incorporate behavioural biases in structuring a client’s asset allocation.

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SUMMARY
By the end of this chapter, you will be able to:
1. Describe the theory of behavioural finance.
• Behavioural finance is commonly defined as the application of psychology to understand human behaviour in
finance or investing.
• The discussion of behavioural finance can be split into two subtopics:
« Behavioural Finance Micro, which looks at the irrational behaviour of individual investors.
• Criticizes perfect rationality, perfect self-interest, and perfect information.
« Behavioural Finance Macro, which looks at irregularities in the overall market.
• Three main types of market anomalies are fundamental anomalies, technical anomalies, and calendar
anomalies.

2. Explain the benefits of using the principles of behavioural finance when working with clients.
• Successful advisory relationships share at least four fundamental characteristics:
« The advisor understands the client’s financial goals.
« The advisor uses a structured, consistent approach to advising the client.
« The advisor delivers what the client expects.
« Both the client and the advisor benefit from the relationship.

3. Explain the drawbacks of traditional risk tolerance questionnaires.

• They often fail psychologically biased individuals.
• They can generate different results when administered in slightly varying formats to the same individual
investor.
• They are mostly administered at the beginning of the advisory relationship and are never revisited.
• Many advisors interpret the results too literally.
• Framing bias is sometimes inherent in the design of questions.
4. Identify cognitive and emotional client biases.
• A cognitive bias can be technically defined as basic statistical, information processing or memory errors that
are common to all human beings.
« Common cognitive biases are: overconfidence, representativeness, anchoring and adjustment, cognitive
dissonance, availability, self-attribution, illusion of control, conservatism, ambiguity aversion, mental
accounting, confirmation, hindsight, recency, framing.
• An emotional bias originates from impulse or intuition rather than from conscious calculations.
« Common emotional biases are: endowment, self-control, optimism, loss aversion, regret aversion,
status quo.

5. Incorporate client bias diagnoses into strategic asset allocation discussions and decisions.
• Moderate biases in less-wealthy clients; adapt to biases in wealthier ones.
• Moderate cognitive biases; adapt to emotional ones.
• In some cases, heeding these two principles simultaneously yields a blended recommendation.

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 SECTION 3

ASSET ALLOCATION AND

INVESTMENT STRATEGY

3 Asset Allocation and Investment Strategy

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 Asset Allocation and
Investment Strategy 3

CONTENT AREAS

What Constitutes An Asset Class?

What Is Asset Allocation and What Are Its Benefits?

What Are Asset Allocation Strategies?

What Are Equity Investment Strategies?

LEARNING OBJECTIVES

1 | Describe the steps in the asset allocation process.

2 | Explain the benefits of asset allocation.

3 | Identify the key decisions associated with asset allocation.

4 | Describe the two ways in which a mean-variance optimizer can suggest a strategic asset
allocation for an investor.

5 | Assess the factors in deciding an appropriate rebalancing strategy.

6 | Explain the methods used to formulate a strategic or tactical asset allocation.

7 | Construct an asset allocation for a client.

8 | List the advantages and disadvantages of different investment strategies.

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INTRODUCTION
The investment advisor begins work on the client’s asset allocation by deciding which asset classes to include in, and
which to exclude from, a client’s portfolio. The customary approach to asset allocation is first to designate the asset
classes to be included in the portfolio in terms of cash, debt securities, and equity securities, and then to determine
the normal or long-term benchmark weights for each of the asset classes allowed in the portfolio. The portfolio
must be adjusted periodically to ensure that the actual portfolio weights remain close to the target weights. If a
tactical approach is used, the advisor may also recommend altering the mix from the benchmark weights to capture
excess returns caused by expected short-term fluctuations in asset-class returns.
Once the benchmark asset allocation is chosen, the investment advisor and client should develop an investment
strategy to guide the selection of individual securities or managed products for the portfolio.

WHAT CONSTITUTES AN ASSET CLASS?

An asset class is a specific category of assets or investments, such as cash, stocks, and bonds. Assets within the
same class generally exhibit similar characteristics and, most importantly, behave in a somewhat similar manner in
the marketplace.
To be considered a separate asset class, a number of criteria need to be satisfied. Although there is no one definitive
set, the following list contains the major standards generally used to define an asset class.
1. Homogeneity within the asset class: All securities included in the class should be more conceptually similar to
each other than to securities excluded from the class.
2. Correlation of returns: Returns of securities included in the class should be more highly correlated with each
other than with returns of securities outside the asset class.
3. Availability of pricing and composition data: All securities in the asset class should be defined in clear and
unambiguous terms.
4. Investability: It should be possible to invest in the asset class passively and at quoted prices.

WHAT IS ASSET ALLOCATION AND WHAT ARE ITS BENEFITS?

Asset allocation is the general term used to describe the process of determining the appropriate proportions for
different asset classes in an investor’s portfolio and maintaining those proportions over time. For most individual
investors, the process involves three strategies:

Strategic asset allocation The strategic asset allocation (SAA) is the benchmark asset mix designed to achieve
the client’s longer-term objectives while taking into account any constraints. The
SAA also incorporates the expectations of the investment advisor or the advisor’s
firm for the return, risk, and correlation among the asset classes. Once set, the
SAA becomes a benchmark against which the performance of the client’s portfolio
can be measured. Strategic asset allocation is sometimes called policy, passive, or
benchmark asset allocation.

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Portfolio rebalancing Portfolio rebalancing is also called dynamic asset allocation. The client’s portfolio
must be rebalanced periodically to maintain the desired asset mix over the long
term. Rebalancing is necessary because the actual asset mix will change as dividends
and interest payments are made and as market prices and economic conditions
change. Rebalancing is covered in more detail later in the chapter.

Tactical asset allocation A tactical asset allocation (TAA) strategy is a decision by the client and investment
advisor to temporarily change the client’s original SAA to take advantage of
perceived opportunities created by short-term fluctuations in the relative
performance of asset classes. TAA operates within limits determined by minimum
and maximum asset class weights. Tactical asset allocation is also occasionally
called active asset allocation.

Together the three strategies are sometimes referred to as integrated asset allocation.
Clients derive the following benefits from using an asset allocation strategy.

Asset allocation accounts A well-known and often-cited 1986 study by Brinson, Hood, and Beebower*
for most of the variation indicated that the strategic asset allocation selected accounted for 93.6% of
in a portfolio’s long-term the variation in returns on very large investment portfolios. Other studies have
returns supported this finding, concluding that the asset allocation, rather than security
selection and market timing decisions, had the greatest impact on the variability of
total portfolio returns.
* Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,”
Financial Analysts Journal (July/Aug. 1986): 39–44.

The strategic asset Portfolios are subject to two kinds of risk: systematic (related to the market)
allocation is designed to and unsystematic (related to the individual security). The goal of strategic asset
be an optimal investment allocation is to lower systematic risk and eliminate unsystematic risk.
portfolio

Asset allocation allows In the absence of a clear SAA, goal setting – and measuring progress against those
meaningful performance goals – would be difficult. For example, an SAA of 5% cash, 35% debt securities, and
measurement 60% equities allows for performance comparisons against a benchmark portfolio of
similarly weighted money market, bond, and stock indexes. The SAA also allows for
meaningful performance attribution, which explains returns in terms of the relative
contributions of asset allocation and security selection. SAA and performance
attribution can also be used to assess the results of tactical asset allocation
strategies. A successful TAA strategy would outperform the SAA benchmark,
whereas an unsuccessful TAA strategy would underperform it.

Long-term investment A properly structured asset allocation strategy imposes discipline on the investment
objectives are kept in focus process in two ways. First, the rebalancing strategy ensures that the portfolio
continues to reflect the policy and design of the original SAA and therefore the
client’s long-term investment objectives. Second, when rebalancing, the SAA helps
advisors and clients decide whether adding new asset classes or securities to the
portfolio would aid in meeting the long-term investment objectives. For example, an
asset class might be considered for inclusion in a portfolio if it could reduce overall
volatility.

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 CHAPTER 3 | ASSET ALLOCATION AND INVESTMENT STRATEGY 3 •5

Tactical asset allocation As will be explained later in the chapter, timely shifts out of overvalued asset classes
allows for opportunities into undervalued ones will add performance beyond that using strategic asset
to realize enhanced allocation alone. Note, however, that not all tactical asset allocation programs are
returns through successful successful.
portfolio tilting

WHAT ARE ASSET ALLOCATION STRATEGIES?

STRATEGIC ASSET ALLOCATION

Strategic asset allocation (or investment policy asset mix) refers to establishing the long-term benchmark asset
mix of the various asset classes. The overall objective is normally based on balancing the need to control inflation,
interest rate, and market risk against the desire for enhanced returns.
The goal of strategic asset allocation is to design an optimal, or efficient, portfolio for which the expected return
is maximized for a given level of risk or, equally, the risk is minimized for a given expected return. The SAA should
not only result in an optimal portfolio, but it should also be consistent with the client’s return objective and risk
tolerance.
Strategic asset allocation is a process both the investment advisor and institutional fund manager should follow.
For the advisor, the task revolves around deciding on an asset mix and then selecting from among various managed
products to fill the mix, adjusting and rebalancing as necessary. Asset allocation for an institutional fund manager
typically involves working within a mandate to decide on an asset mix and then choosing individual securities from
the selected asset classes based on tactical expectations.
Strategic asset allocation is the most important decision of the investment management process. The establishment
of the SAA mix flows from the process itself and requires the following steps:
• Establish client objectives and constraints;
• Specify asset classes eligible for the portfolio;
• Specify capital market expectations;
• Derive the efficient portfolio frontier;
• Find and set the optimal asset mix.

ESTABLISH CLIENT OBJECTIVES AND CONSTRAINTS

Investment policy cannot be established in a vacuum. It must be determined within the context of client needs and
investment horizons.
As mentioned previously, factors influencing investment policy include the client’s return objective, risk objective,
time horizon, liquidity needs, legal constraints, tax considerations, and other special circumstances. Goals and
objectives often conflict with one another, and investors with short horizons face different risks than do long-term
investors. A low-risk strategy for a short-term investor could be a high-risk strategy for a long-term investor.
Goals and objectives should be clearly articulated. For example, some investors set portfolio achievement goals
based on improving their purchasing power, such as:
• Earning an average portfolio return of 4% above the inflation rate
• Beating a North American inflation index by 2% per annum

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Other investors set goals based on outperforming a market index, such as:
• Earning a risk-adjusted rate of return above the S&P/TSX Composite Index
• Outperforming the S&P/TSX 60 Index by 2% per annum

Still other investors might articulate a benchmarking strategy, such as:

• Earning a return equal to a weighted average portfolio consisting of 20% treasury bills, 30% bonds, and 50%
stocks as measured by the FTSE TMX Canada 91 Day T-Bill Index, the FTSE TMX Canada Universe Bond Index,
and the S&P/TSX Composite Index
• Earning a return equal to that of the MSCI World Index

Setting realistic and quantifiable goals imposes discipline on the investment process. Furthermore, it creates
standards for measuring the portfolio’s progress over time.
An important issue facing investment advisors is the formulation of strategic asset allocations for clients with
multiple time horizons. Advisors should aim for a single strategic asset allocation for a client’s entire investment
portfolio at any given time, balancing the client’s objectives and constraints across one relatively long-term time
horizon.
High-priority short-term goals that entail significant portfolio cash outflows relative to the overall size of the
portfolio are difficult to accommodate when they conflict with longer-term goals. The strategic asset allocation
should be flexible enough to meet both needs.

EXAMPLE
Consider a couple in their early 40s. They have just inherited $750,000. Before they received the inheritance,
their portfolio consisted of $100,000 held in RRSPs. Their only goal for their portfolio before the inheritance was
to have enough to fund their retirement in 25 years.
The first thing the couple does is use $250,000 of the inheritance to pay off their mortgage and other debts. They
want to use half the remainder – about $250,000 – to buy a vacation property in two years and add the other
half to their RRSPs. They have multiple goals with multiple horizons. The challenge for the couple’s investment
advisor is to come up with a strategic asset allocation that addresses both their short- and long-term goals.
Assuming no additional cash flows into the portfolio over the next two years, the advisor can recommend
investing $240,000 in a two-year Government of Canada strip coupon yielding 4%. When the strip bond
matures, the investors can use the cash to buy a vacation property. The face value of the bond is $260,000,
which, after deducting taxes payable on the effective interest income, will give them about $250,000. For the
RRSPs, now valued at $360,000 (the original $100,000 plus $260,000), the investment advisor recommends a
split of 5% cash, 25% debt securities, and 70% equities.
By following these recommendations, the couple can meet their short-term goal without worrying about the ups
and downs of the market. The strategic asset allocation to meet their retirement goal would be:

Asset Class Strategic Asset Allocation (%) Dollar Value

Cash and Cash Equivalents 5 $18,000
Debt Securities 25 $90,000
Equity Securities 70 $252,000
Total 100 $360,000

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 CHAPTER 3 | ASSET ALLOCATION AND INVESTMENT STRATEGY 3 •7

EXAMPLE
Cont'd
The couple’s actual asset allocation, including the shorter-term vacation property goal, is:

Asset Class Strategic Asset Allocation (%) Dollar Value

Cash and Cash Equivalents 3 $18,000
Debt Securities 55 $330,000
Equity Securities 42 $252,000
Total 100 $600,000

SPECIFY ASSET CLASSES ELIGIBLE FOR PORTFOLIO

The next step is to decide which asset classes to consider for the portfolio mix. Typically, portfolio managers can
choose from real and financial assets, although the constraints of a client or the bylaws and guidelines of the
underlying managed product may restrict certain investments. For example, some managers are not permitted to
use derivative products. In other cases, clients place specific restrictions on the manager’s investment opportunity
set. Some may place ethical screens to prohibit the manager from investing in specific types of companies; others
may be opposed to investing in real estate or gold.
Traditionally, there were only three broad asset classes: cash, debt securities (also known as bonds or fixed-income
securities), and equities. These three classes, however, are no longer adequate for a modern asset allocation
strategy. Investment markets have evolved and different financial products are now available for investment. In
addition, it is often necessary to define debt and equity securities more narrowly based on certain characteristics of
these securities.
An advisor should combine low- or negative-correlation assets to build the lowest-variance, highest-return
portfolio possible.

SPECIFY CAPITAL MARKET EXPECTATIONS

The next stage in the strategic asset allocation process is to develop a set of capital market expectations for the
various asset classes being considered for the portfolio mix. These expectations specify returns, variances, and
covariances (correlation coefficients) among the various asset classes. Development of capital market expectations
is, after the establishment of client objectives and constraints, the other key step in determining asset mix.
Expectations are normally based on historical asset class results, including average returns, standard deviations, and
correlation matrices for each asset class. These historical data are adjusted for current economic forecasts based
on prevailing economic scenarios and probability of occurrence. Capital market expectations are normally revised
at least quarterly as new information is released, but are sometimes reviewed as often as weekly. The sources for
forecasts are historical short-, medium-, and long-term asset class returns and economic forecasts.
Historical asset class returns are not always the best estimate of future returns. Long-term average returns can
be misleading. The best-performing asset classes in a given period may not perform well in the next period.
Consistently picking the best asset classes every year is difficult.
Over time, relationships among asset classes also change. As a convenience, relationships are assumed to be
constant when expected returns are calculated. Correlations, standard deviations, and risk premiums do not remain
constant, however.

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It is critical that the portfolio manager examine the stability and strength of asset class returns. Since forecasts are
typically based on five-year periods, recent trends and potential changes in asset class returns should be examined
together. Forecasts must reflect the economic cycle.
There are different approaches to formulating capital market expectations. In one approach, the portfolio manager
can formulate an expected scenario and base the return, standard deviation, and correlation matrix on this.
Alternatively, a fund manager can forecast different prevailing scenarios and attach probabilities of occurrence to
each. For example, the following is what a five-year forecast might look like (which may be adjusted as frequently
as monthly, depending on the investment approach used by the manager). It attaches a 40% probability to
“normal growth” conditions prevailing, 10% probability to both “superprosperity” and “mostly recession,” and 20%
probability to both “prosperity” and “stagflation.” Assume that these expectations were based on historical asset
class returns adjusted for current economic conditions.

Bonds Stocks Stocks Stocks Real

Asset Class T-bills Mortgages Can. Can. U.S. EAFE* Estate
Prob.
Economic Scenario Occur
Superprosperity 0.10 6.0% 9.0% 12.0% 32.0% 36.0% 44.0% 24.0%
Prosperity 0.20 6.0 –1.0 –8.0 18.0 21.0 19.0 16.0
Normal Growth 0.40 5.0 8.0 9.5 11.5 15.0 13.0 3.0
Stagflation 0.20 4.0 9.0 14.0 1.0 –4.0 –2.0 11.0
Mostly Recession 0.10 4.0 5.0 2.0 –9.0 –13.0 –9.5 –8.3
Expected Return 5.0 6.2 6.4 10.7 11.7 12.1 8.2
Standard Deviation 0.8 3.9 8.0 12.1 15.4 15.7 9.3

* EAFE = Europe, Australasia and the Far East

The expected return is simply the sum of the weighted average of the projected returns (the returns times the
probabilities in each state). The standard deviations are probability-weighted deviations from each asset class’s
expected return (the calculation of the probability-weighted standard deviation is beyond the scope of this course).

DERIVE THE EFFICIENT PORTFOLIO FRONTIER

First, the portfolio opportunity set (the set of all possible asset combinations) is derived from capital market
expectations and their probability distributions. Then from this set, the efficient frontier – the highest-return
portfolio at each risk level – is identified.

FIND AND SET THE OPTIMAL ASSET MIX

The next step in arriving at the strategic asset allocation is to integrate capital market expectations and risk
tolerances to produce the long-term asset mix that reflects the optimum portfolio at the investor’s risk level.
The optimum portfolio is selected using one of three methods:
• Mean-variance analysis
• Rules of thumb
• Ad hoc approach

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MEAN-VARIANCE ANALYSIS
Mean-variance analysis relies heavily on the precepts of modern portfolio theory. The key lesson of portfolio theory
is that investors can reduce the total risk of their portfolios by owning smaller amounts of a group of less-than-
perfectly correlated assets instead of large amounts of a single asset. Mean-variance analysis can determine a
strategic asset mix in one of two ways.
1. A pure mean-variance analysis requires the investment advisor to include information on capital market
expectations and to estimate a numerical value for the client’s risk tolerance. The specific analysis provides
guidance on how to estimate the risk tolerance variable. Using this information, the pure optimizer, a quadratic
formula that maximizes investor utility, recommends a single strategic asset allocation that is both efficient
and acceptable given the client’s risk tolerance.
2. Other optimizers require only a set of capital market expectations as input. Using this information, they
produce several recommended asset allocations, all of which are efficient. The advisor then simply selects
what he feels is the appropriate asset allocation for the client based on the client’s return objective and risk
tolerance.

The quality and integrity of the inputs are critical to mean-variance analysis. Relatively small changes to the inputs
can result in significant changes to the recommended allocation. If historical data are used as the basis for capital
market expectations and if future performance does not closely resemble that of the past, the recommended
portfolio may be far from optimum.
Mean-variance analysis may occasionally recommend a large, or even negative (that is, short), position in certain
undesirable asset classes. For instance, given a certain set of capital market expectations, an optimizer might
recommend an allocation of 5% cash, 10% debt securities, 10% Canadian equities, 10% U.S. equities, and 65%
international equities. Most clients would not be comfortable holding a portfolio with such a large weighting in
international equities, no matter how efficient it might be.
This less desirable mix can be avoided if the investment advisor includes a list of asset class constraints along with
the capital markets expectations. For instance, the advisor could impose a limit of no more than 20% international
equities. Asset class constraints may be those stated explicitly in the client’s investment policy statement or they
can be based on the advisor’s own professional judgement.
Some investment dealers provide their investment advisors with a list of several strategic asset allocations based on
an in-house optimizer. The allocations are often divided into generic risk tolerance categories, such as low, medium,
and high. Advisors can then select an allocation appropriate for a particular client’s objectives and constraints.
Investment advisors who use mean-variance analysis to construct an SAA may find that the technique is not easy
to explain to the average client. The process may appear to be a black box solution in which a computer spits out a
recommendation to a client, who has little understanding of the theory involved in producing the result.

RULES OF THUMB
Although rules of thumb may sound unprofessional and somewhat like guesswork, they are nonetheless popular
because they often work and are simple to implement. There is a tendency in modern investment management to
make it appear that investing is exceptionally complicated. In truth, an investment advisor who fully understands
and considers the client’s needs and has reliable capital market expectations is capable of producing a sensible
strategic asset allocation recommendation using rules of thumb, some of which are described below.

TIME DIVERSIFICATION APPROACH

Most rules of thumb are based on an assumption of time diversification. Time diversification means that over the
long term, the return/risk trade-off for equities improves over that of all other asset classes, and therefore the longer
the time horizon, the lower the risk of holding equities. Indeed, over longer periods, volatility as measured by annual
standard deviation is usually lower than it is for shorter periods and returns are more likely to exceed treasury bills
returns.

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A belief in time diversification usually leads to a recommendation that younger clients hold a greater percentage of
their portfolios in equities than older clients would because equities offer the greatest expected return.
Whether time diversification holds true or not is a matter of long-standing debate in the academic investment
community. The debate, though, is not so much about time diversification as it is about the true definition of risk
and whether standard deviation alone is an acceptable proxy for investment risk. Certainly the standard deviation of
10-year returns is generally lower than the annualized standard deviation. If risk is defined as the variability of final
wealth, however, risk actually increases over longer periods. The number of outcomes of the final wealth one could
possibly hold becomes more varied over time. If the risk of not achieving a final wealth goal increases over time,
it may make more sense for a younger investor to invest more heavily in bonds because of the more predictable
stream of longer-term returns.

AGE APPROACH
The age approach to strategic asset allocation recommends a specific SAA based solely on the client’s age. The age
approach suggests an allocation to debt securities (including cash and cash equivalents) equal to the client’s age.
With this rule, the allocation to equities equals 100 minus the client’s age.

EXAMPLE
If a client is 35 years old, the age approach to strategic asset allocation suggests a 65% weight in equities and a
35% weight in debt securities. As the client approaches retirement, the allocation to debt securities will increase
and the allocation to equities will decline. By retirement at age 65, the suggested allocation will be 35% in
equities and 65% in debt securities.

AD HOC APPROACH
The final method of strategic asset allocation used by some investment advisors is the least desirable and is the
least grounded in theory. The discussion here is not a recommendation of this approach, but simply a presentation
of it as an approach that is sometimes used.
An ad hoc approach to strategic asset allocation is simply an investment advisor’s opinion of, or gut feeling for, what
the SAA should be. The advisor may or may not consider capital market expectations, but in either case, the client’s
objectives and constraints must be central to the decision. To do anything less would be a great disservice to the
client and may in fact be grounds for potential legal action by the client.

DYNAMIC ASSET ALLOCATION

Once a long-term investment policy mix is established, a dynamic rebalancing policy is needed. Dynamic asset
allocation refers to the systematic rebalancing, either temporally or based on weights, needed to return the
portfolio to the long-term benchmark asset class mix. Maintenance of the mix can be a challenge.
In general, rebalancing reflects the following basic assumptions:

Capital market expectations If capital market expectations change, all calculations underlying the asset mix are
remain constant redone.

Risk tolerance remains If risk tolerance changes, the efficient frontier remains intact but the optimum
constant portfolio changes. It is quite likely that risk tolerance will change as wealth
increases. If high nominal returns are earned for an extended period, clients may
become more (or less) risk tolerant.

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Investment objectives If objectives change, the efficient frontier remains intact but the optimum
remain constant portfolio changes. This, in fact, underscores the famous separation theorem of
finance – namely, that the efficient frontier is determined independently of a
specific investor’s objectives.

The asset mix may drift from the target because of structural or procedural administrative matters, abnormal
returns within asset classes, or changing capital market conditions. More specifically, policy drift will occur if:
• There are idle cash reserves possibly from dividends or interest income earned over time and not yet invested.
• There are abnormal movements in capital markets such as the 1987 U.S. stock market crash or the 2008 global
financial crisis.

If there is a clear dynamic policy, the risk of policy drifting is mitigated.

The following points highlight the value of rebalancing:

The integrity of the asset The time and effort spent establishing the long-term policy mix is not wasted.
mix is enforced

Value may be added to Asset classes tend to revert to their long-term average performance. By
performance with counter- rebalancing, the portfolio may avoid losing gains from reversion to the mean.
cyclical selling and buying

Discipline is enforced Rebalancing forces discipline because it makes managers and decision-makers
stick with the policy during unfavourable periods.

Portfolio risk is controlled If higher-risk assets earn higher-than-average returns and the portfolio is allowed
to drift, the higher-risk assets will represent ever-larger proportions of the
portfolio over time. Portfolio risk becomes greater than what was established as
acceptable in the investment policy statement.

Rebalancing dampens returns in a strong market because by rebalancing, the portfolio manager is reducing the
proportion of the best-performing component. Rebalancing enhances returns in a weak market through the
purchase of the weaker asset class at reduced prices. Rebalancing is often accomplished with derivatives. For
example, if stock prices have risen, selling index futures could be more efficient than selling stocks.
Following is a simple example of dynamic rebalancing for a $100 million portfolio.
A fund manager starts the year with $100 million in the portfolio. There is $20 million in money market mutual
funds, $30 million in bonds, and $50 million in equities. The target is to maintain this 20/30/50 cash/fixed income/
equities mix. Here is what the portfolio looks like at the start of the year:

Component Value Weight (%)

Cash $20 million 20
Fixed Income $30 million 30
Equities $50 million 50
Total $100 million 100

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As a result of the strong performance of the equity component, the portfolio has grown by 22.0% and the
composition is now $21 million, $32 million, and $69 million. The portfolio now looks like this:

Component Value Weight (%)

Cash $21 million 17.2
Fixed Income $32 million 26.2
Equities $69 million 56.6
Total $122 million 100.0

There are various approaches to adjusting the portfolio back to the desired mix. One method is to simply sell
and buy securities. To restore the desired mix for the $122 million portfolio, the required value of the individual
components of the portfolio has to look like this:

Component Required Value Target Weight (%)

Cash $24.4 million 20
Fixed Income $36.6 million 30
Equities $61.0 million 50
Total $122 million 100

To arrive at the required values, multiply each target weight by the total value of the portfolio. For example, to
determine the cash value, multiply $122 million by 20%. To determine the required adjustments, subtract the
current value of the portfolio components from the required value to get the difference. For the sample portfolio,
the manager needs to sell $8 million worth of equities and buy $3.4 million in money market funds and $4.6
million in bonds.

Component Target Weight (%) Required Value Current Value Difference

Cash 20 $24.4 million $21 million $3.4 million
Fixed Income 30 $36.6 million $32 million $4.6 million
Equities 50 $61.0 million $69 million –$8 million
Total 100 $122 million $122 million

The two most commonly employed dynamic rebalancing strategies are temporal and weight-based.

TEMPORAL REBALANCING
Temporal rebalancing involves rebalancing a portfolio back to target weights periodically – for example, monthly,
quarterly, semi-annually, or annually. The choice of rebalancing frequency is sometimes linked to the schedule of
portfolio reviews.
Temporal rebalancing is the simplest rebalancing discipline. It does not involve continuously monitoring portfolio
values within the rebalancing period. If the rebalancing frequency is adequate given the portfolio’s volatility,
temporal rebalancing can ensure that the actual portfolio does not drift far from target for long.
One drawback of temporal rebalancing is that the strategy calls for rebalancing regardless of market conditions. On
any given rebalancing date, the portfolio could be either very close to or far from optimal proportions. In the former
case, the portfolio might be nearly optimal and the costs of rebalancing could swamp the benefits. In the latter case,
it is possible that by rebalancing, an investor could incur unnecessarily high costs in terms of market impact – that
is, the price of a security could change because of the order to buy or sell it.

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WEIGHT-BASED REBALANCING
Rebalancing based on weight is an alternative to temporal rebalancing. Weight-based rebalancing involves setting
rebalancing thresholds or trigger points that are a percentage of the portfolio’s value. For example, if the target
proportion for an asset class is 40% of portfolio value, trigger points could be at 35% and 45% of portfolio value.
Thus, 35% to 45% (or 40% ± 5%) is the corridor or tolerance band for the value of that asset class. The portfolio is
rebalanced when an asset class’s weight passes through one of its rebalancing thresholds.
For example, consider a three-asset-class portfolio of Canadian equities, international equities, and Canadian bonds.
The respective target asset proportions and corridors are 45% ± 4.5%, 15% ± 1.5%, and 40% ± 4%. Suppose the
portfolio manager observes the actual allocation to be 50/14/36; the upper threshold (49.5%) for domestic equities
has been breached, so the asset mix would be rebalanced to 45/15/40.
The width of the corridor for each asset class can be set ad hoc (for example, ± 10% for all equity classes). This
approach, however, does not account for the fact that some asset classes are more expensive to transact than others.
Instead of using ad hoc corridors, managers should use at least five factors in setting the corridor for an asset class:
• Transaction costs
• Tolerance for tracking risk versus the strategic asset allocation
• Correlation with other asset classes
• Volatility
• Volatilities of other asset classes

The more expensive it is to trade an asset class (or the lower its liquidity), the wider its corridor should be, because
the benefit of rebalancing must at least equal the cost. The higher the risk tolerance (that is, the lower the investor’s
sensitivity to straying from target proportions), the wider corridors can be.
A high correlation between a particular asset class and the remainder of the portfolio should also lead to wider
tolerance bands. In a portfolio of highly correlated asset classes, the relative weights of each class are not likely to
stray far from their targets; tolerance bands can be wider. Conversely, when correlation between a portfolio’s asset
classes is low, it is possible for one asset class to move quite a distance from its target allocation. A narrow tolerance
band is needed to control that class’s relative weight in the portfolio.
Higher asset-class volatility should lead to a narrower corridor, all else being equal. Being a given percentage off
target in a more volatile asset class is more damaging because high-volatility classes have a greater chance of a
further large move away from target. The more volatile the remainder of the portfolio, the more risk there is in being
a given percentage off target for the single asset class.
Rebalancing trades can occur anytime if the manager is using a weight-based rebalancing strategy, in contrast to
temporal rebalancing. Compared with temporal rebalancing (particularly at lower frequencies such as semi-annually
and annually), rebalancing based on weight can provide tighter control of divergence from target proportions
because it is directly related to market performance.
Rebalancing based on weight requires regular monitoring of portfolio values to identify instances when a trigger
point is breached. Daily monitoring provides the greatest precision.
Although weight-based rebalancing is theoretically the better approach, the more practical method is temporal
rebalancing; that is, reviewing and adjusting the mix periodically, such as semi-annually or annually.

TACTICAL ASSET ALLOCATION

Tactical asset allocation is an active management strategy employed to add value by temporarily departing from
the long-term policy asset mix (as distinct from changing the policy mix itself). It is the attempt to respond to the
changing patterns of returns in the market. In a tactical strategy, equities may be sold after a market rally on the
assumption that returns will be suppressed in the future.

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Tactical asset allocation is the process of tilting a portfolio to take advantage of perceived inefficiencies in the prices
of securities in different asset classes or in different sectors within a class. The portfolio’s policy statement often
defines a range for such tactical tilting that goes beyond the strategic asset weightings. TAA can take the form of
tilting by asset class (such as overweighting stocks over bonds) or tilting within asset classes in the form of sector
rotation, underweighting or overweighting to specific sectors, or other variations.
For example, bonds and stocks have performed very well in disinflationary environments and are both considered
hedges against disinflation. A portfolio manager, believing that the economy is entering a disinflationary period,
might change the asset allocation away from cash to bonds and stocks. Alternatively, the manager may choose to
tilt within the fixed-income class – that is, changing the average duration or maturity of the portfolio.
Tactical asset allocators believe that investment policy should not be static. Simply picking, for example, a 10%
cash, 30% fixed income, and 60% equities investment policy and sticking to it is inappropriate because the
investment environment is constantly changing. Normally, therefore, a particular tactical asset allocation strategy
is short-lived, spanning a few weeks or a few months. Portfolio managers should use tactical asset allocation only if
they believe that active shifts can add value.
Tactical asset allocation operates independently from risk tolerance – a change in risk tolerance could give rise to a
change in strategic asset allocation, but TAA assumes constant risk tolerance.

TACTICAL ASSET ALLOCATION STRATEGIES

Tactical asset allocation strategies are either value-based or cyclical.

VALUE-BASED TACTICAL ASSET ALLOCATION

Value-based approaches to TAA mean identifying times when an asset class is cheap or expensive by comparing the
relative value of that class with the values of all other asset classes.
Value-based TAA often uses an analysis of risk premiums. Risk premiums are measures of the expected return on an
asset class minus the expected return on another asset class. Some of these risk-premium relationships are:

Stocks/T-bills risk The expected return on equities minus the expected return on Treasury bills.
premium

Bonds/T-bills risk The expected return on bonds minus the expected return on Treasury bills.
premium

Stocks/bonds risk The expected return on equities minus the expected return on bonds.
premium

These risk-premium relationships can be compared with their historical norms to determine the relative
attractiveness of various asset classes. The normal relationship is generally taken to be the average premium or
spread over some period in the past. (Some analysts calculate expected risk premiums based on current valuation
measures, such as the price-earnings ratio for stocks and the yield to maturity for debt securities. For example, the
stocks/bonds risk premium can be measured as the earnings yield on stocks – the inverse of the P/E ratio – minus
the yield to maturity on long-term bonds.)
A TAA recommendation to, say, overweight equities and underweight debt securities may be the result of an
expected return on stocks relative to debt securities that is greater than historical norms.

CYCLICAL TACTICAL ASSET ALLOCATION

Stock price and bond yield movements are related to certain macroeconomic changes. Cyclical approaches to TAA
involve monitoring economic activity for patterns that have historically led to stock market movements. Investment
advisors can use these movements as guides in tilting portfolios away from their strategic asset allocations.

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Thus, an investor with a balanced portfolio of equities and bonds might use a cyclical TAA approach to shift
some funds from equities into bonds when, for example, the investor expects that the economy is heading into a
recession. The basis for this decision is the belief that in recessionary periods, bonds will outperform stocks, as has
historically been the case.

THE VALUE-ADDING OF TACTICAL ASSET ALLOCATION

To get a sense of the value of tactical asset allocation, consider a $10 million portfolio constructed as follows: 10%
in T-bills, 30% in long-term Canadian bonds, and 60% in Canadian stocks. Using historical asset-class returns, let’s
say a portfolio of this composition held with re-investment would have returned 10.90% annually for a period of
37 years and would be worth $459.7 million at the end of this period. Now suppose the fund manager successfully
avoided the worst three years in the stock market during that period and invested 100% of the portfolio in T-bills
during those years while maintaining the 10/30/60 split every other year. Now the annual return goes to 12.69%
and the $10 million portfolio would be worth $831.3 million by the end of the 37 year period. If the fund manager
successfully tactically shifted the portfolio every year into the highest-yielding asset class, the return would have
been 19.59% per annum and the $10 million portfolio would be worth almost $7.5 billion by the end of this period.
Although the latter is an extreme and unrealistic case, it demonstrates that the value of tactical trading can be
significant.
How do portfolio managers accomplish tactical shifting? For fund managers, selling and buying actual assets
is the most direct method of accomplishing a tactical shift. It can be very costly, however, since, in addition to
commissions, there may be significant price pressure effects if transactions are large. An alternative is to buy and
sell derivatives such as futures or options. For example, an equity-fund manager might sell stock index futures in an
appropriate ratio to replicate the actual portfolio the fund manager wants. If, for example, the plan is to shift the
asset allocation from a 10% cash, 30% bonds, and 60% equities mix to a 10/40/50 mix for a $10 million portfolio,
selling sufficient stock index futures or buying stock index put options could accomplish the goal. Using derivatives
instead to replicate the desired mix may be less expensive than transacting in the actual stocks. There could be
liquidity constraints, however, depending on the desired size of the transaction.

EMPLOYING TACTICAL ASSET ALLOCATION

There are two approaches to employing tactical asset allocation. The first is to set ranges. To incorporate a TAA
strategy into the overall asset allocation strategy using this approach, the investment advisor and client should
establish a range around each asset class’s strategic asset allocation weight. The ranges indicate the largest
deviation from the strategic asset allocation allowed. For example, if the client establishes a strategic allocation
of 5% cash, 30% debt securities, and 65% equities, the following minimum and maximum ranges could be
established:

Minimum Strategic Asset Maximum

Asset Class Weight (%) Allocation (%) Weight (%)
Cash and Cash Equivalents 0 5 10
Debt Securities 20 30 40
Equity Securities 50 65 80
Total 100

The implementation of a tactical allocation strategy cannot cause the weight of any asset class to fall below the
minimum weight or go above the maximum weight.
In the second approach to TAA, the manager uses a pool of funds within the portfolio for tactical trading and
portfolio tilting.

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COSTS OF TACTICAL ASSET ALLOCATION

Implementing a tactical trading strategy costs money no matter how efficiently or carefully it is done. The most
obvious cost is commissions. Investment dealers and some distributors of managed products charge commissions
for implementing the trades undertaken to shift a portfolio mix. Commissions are charged for stock and bond
trading, for buying front-end load mutual funds, and, in some cases, for selling back-end load mutual funds.
Commissions can, to a certain extent, be controlled. For example, back-end loads for mutual funds are entirely
within the control of the investor. The amount of the back-end load normally diminishes over time, so that the
charge of 6% or 7% of the value of the fund in the first year after purchase declines to zero after six or seven years.
Therefore, by timing the sale of these mutual funds to coincide with the expiration of the back-end load schedule,
costs can be minimized.
Trading also has implicit costs separate from commissions. Market impact is the effect on the market price of a
security caused by an order to buy or sell it. It is rarely a factor for liquid stocks of very large companies, but for
most Canadian small-cap stocks or larger companies that do not trade often, investors making large purchases or
sales can skew the market price against themselves. If few shares are available for sale or purchase at a given price, a
market order to sell or buy can have the effect of depressing the share price to fill the sell order or pushing the share
price higher to fill the buy order. Some studies suggest that market impact can add more than 1% a year to the cost
of running an investment portfolio. In an era of reduced investment return expectations, that can be a major hurdle.

RISKS AND BENEFITS OF TACTICAL ASSET ALLOCATION

The risks of tactical asset allocation are:

Modest or no value TAA may offer little additional performance benefit once transaction and tax costs are
added taken into account. Because TAA means diverging from the strategic asset allocation,
which is designed to meet a client’s long-term objectives, the cost of an unsuccessful
strategy can be high.

Early calls TAA adjustments that try to time performance reversals are usually too early, which can
lead to premature abandonment of a strategy or difficulty in maintaining the TAA. In
addition, short-term investment losses can be incurred.

Shifts in normal A TAA strategy that focuses on valuation models may not incorporate changes in
valuation equilibrium valuations in a timely way, thereby increasing portfolio risk.

The benefits of tactical asset allocation are:

Enhanced returns TAA can enhance returns through successful tilts away from the SAA. This is the main
reason for using TAA.

Lower risk TAA can protect portfolios in down markets. For example, if negative returns are
anticipated for equities, a risk-reducing TAA strategy might be to reduce equity exposure
and/or increase cash reserves or bond exposure.

Flexibility TAA incorporates and responds to short-term market conditions, unlike SAA, which
focuses on long-term capital market conditions.

ASSET LOCATION
Asset location refers to the decision to hold investment assets in taxable, tax-deferred, and tax-exempt accounts to
achieve the greatest after-tax return for a given risk tolerance. This is an important consideration because Canadian
tax laws treat returns from different investments differently for tax purposes.

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Conventional wisdom holds that debt securities, which generate interest income, should always be held in a tax-
deferred account, such as a registered retirement savings plan (RRSP) or a tax-exempt account such as a tax-free
savings account (TFSA), while equity securities, which generate capital gains and dividends, should be held in a
taxable account. The reason for this division is that capital gains and dividends are effectively taxed at lower rates
than interest income, and therefore interest-bearing securities should be held in a tax-deferred account to defer tax
or a tax-exempt account to eliminate tax on these less tax-efficient investments.
Asset allocation becomes an issue, however, for clients who have maximized their RRSP contributions and TFSA
contributions. For investors without significant short-term goals, the first decision in asset location should be to
maximize contributions to their RRSP and TFSA before making any investment outside these types of accounts.

WHAT ARE EQUITY INVESTMENT STRATEGIES?

Once the asset allocation strategies have been devised, the investment strategy to be used for selecting individual
securities or managed products for the portfolio needs to be identified. Strategy is a function of what the manager
or advisor believes about investment finance. Pension fund sponsors routinely allocate the funds entrusted to them
among portfolio managers largely on the basis of management investment strategies. Strategies can be active or
passive, can be bottom-up or top-down, can focus on value or growth or on small- or large-capitalization stocks, or
employ sector rotation.
The key to success is for managers to choose the strategy they are most proficient with and to stick with it. It is
impossible to refine a craft if one is always changing the focus, particularly if the switch is to a strategy that has
been proven not to work.
This discussion of investment strategy is restricted to equity investments. For investment strategies appropriate to
debt securities, see Chapter 10.

PASSIVE AND ACTIVE EQUITY STRATEGIES

An equity investment strategy can be passive or active.
• An active investment strategy uses expectations about individual securities and the overall investment
environment to build a portfolio that will take advantage of those expectations. If the expectations change, the
portfolio will likely change as well.
• A passive investment strategy, on the other hand, does not lead to portfolio changes when expectations
change.

An active investment strategy is an attempt to outperform a benchmark portfolio on a risk-adjusted basis. Investors
can judge the success of their active strategies by comparing their portfolio’s or asset class’s performance to that
of an appropriate benchmark or index. For example, the performance of an equity strategy that focuses on small-
capitalization stocks should be gauged against a small-cap equity index.
Since time and other resources are spent acquiring and analyzing information, active investors may underperform
those who spend no time or money analyzing market information and who simply invest in a well-diversified
market index or benchmark portfolio. When deciding whether to pursue an active investment strategy, investors
must decide whether they think it is possible to earn more with an active strategy than with a passive strategy,
and whether the additional amount they earn at least equals the costs of pursuing the active strategy. If not, the
investor would be wasting resources trying to beat the benchmark.

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Besides reflecting investors’ beliefs about market efficiency, the chosen investment strategy must be consistent
with the investor’s investment objectives and constraints. A passive investment strategy, for example, is consistent
with a return objective equal to the expected return on the benchmark portfolio. If the objective is to outperform
the expected return on the benchmark, a passive strategy is not appropriate. Only an active strategy offers the
possibility of outperforming the benchmark.
Of course, investors (and investment advisors) do not have to select one strategy over another. Many investors
mix passive and active investment strategies when they construct their portfolios. One approach is to use a passive
strategy for a core portion of the portfolio or asset class and an active strategy on the non-core portion.

EFFICIENT-MARKET HYPOTHESIS
The choice of investment strategy depends on the investor’s belief in market efficiency.
Please recall from Chapter 2 that the efficient-market hypothesis states asset prices reflect available information
in efficient markets. This theory has three forms, each of which assumes that a different amount of information is
reflected in asset prices:

Weak form Current prices incorporate all information about past prices, volumes, and returns. This
implies that technical analysis cannot consistently beat the market.

Semi-strong form Current prices reflect all publicly available information. This implies that neither
fundamental nor technical analysis can be used and will do nothing to help investors
beat the market.

Strong form Prices reflect all information, including insider information. This implies that no type of
further analysis is helpful in beating the market.

If the strong form of the efficient-market hypothesis is valid, then investors cannot earn excess risk-adjusted returns
by carrying out research and analysis, because all information about the true value of all traded assets is already
incorporated into their prices (an excess risk-adjusted return is a return higher than the expected return, given the
asset’s level of risk). This rationale justifies passive trading strategies.
Some investors assume that markets are efficient and that there is no point in spending resources on research and
excess management fees in an attempt to outperform the market; the belief is that those expenses reduce returns.
These investors use a passive investment strategy, such as indexing or buy-and-hold. In contrast, investors who
believe that the market is not efficient use active investment strategies to attempt to outperform the market.

PASSIVE EQUITY STRATEGIES

The two most widely recognized passive strategies are indexing and buy-and-hold.
Indexing is by far the most popular form of passive investing. An indexed portfolio is designed to track the
performance of a specific market index. Indexing is supported by a belief in the strong form efficient-market
hypothesis, but investors do not necessarily need to believe in the efficient-market theory to index. Investors may
simply not have the time, resources, or inclination to follow an active strategy. And given the variety of indexes
available to investors, an indexing strategy can be tailored somewhat to an investor’s objectives and constraints.
The advantages of an indexing strategy include:
• A low risk of underperforming the benchmark
• Fees that are usually lower than those associated with most active strategies
• The fact that the strategy does not depend on the ability of the client or investment advisor to select securities
or managed products that will outperform the benchmark

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There are, however, disadvantages to indexing, including:

• Potential underperformance relative to active strategies
• The risk that the index return does not meet portfolio objectives or constraints
• Lack of assurance that the performance of the index will be matched, given the varying methods of indexing

Most individual investors can implement an indexing strategy by buying an index mutual fund or exchange-traded
fund. With a buy-and-hold strategy, the investment advisor and client select a group of securities or managed
products and the client holds them until he or she needs to sell them to meet investment goals. The buy-and-hold
approach has an initial active component because the client and advisor must first decide what securities to buy.

ACTIVE EQUITY STRATEGIES

Active equity investment strategies can be separated into two groups based on the approach used to select stocks
for purchase or sale: bottom-up or top-down. Investment advisors and clients who pick individual stocks can use
either of these approaches to guide their selections. Advisors and clients who use managed products can ask the
fund manager which approach he or she uses.
Bottom-up approaches begin with a focus on individual stocks. Investors or portfolio managers look at
the characteristics of individual stocks and build portfolios of the best stocks in terms of forecast risk-return
characteristics. Some investors use screening procedures to identify stocks that have particular attributes believed
to be associated with superior investment performance. The choice of screening criteria is often based on historical
stock returns.
Other bottom-up approaches use a more technical approach in which stocks are bought or sold based on patterns
on stock charts or based on statistical analysis of historical trading data.

BOTTOM-UP APPROACHES
Bottom-up approaches to equity analysis can be classified as style-based or non-style-based.
• Style-based approaches involve focusing on a particular set of stocks that have similar fundamental
characteristics and performance patterns.
• Non-style-based approaches do not focus on a particular group of stocks but involve a search for stocks with
the best chance of meeting particular objectives.

STYLE-BASED
Although there are competing definitions of exactly what constitutes an equity style, two of the most popular
definitions distinguish between value and growth stocks and between large-capitalization and small-
capitalization stocks.

Value and Growth While there are different ways to define value and growth stocks, the company’s price-
to-book (P/B) ratio, which compares the company’s stock price to the book value per
share, is the most commonly used factor. In addition to P/B ratios, growth and value
stocks are sometimes distinguished by their price-earnings (P/E) ratios and dividend
yields. Value stocks tend to have low P/E and P/B ratios and high dividend yields, while
growth stocks have high P/Es and P/Bs and low dividend yields.

Investors and portfolio managers who buy growth stocks tend to focus on a company’s earnings. They consider
growth stocks to be those with above-average potential for future earnings growth. They believe that higher
earnings growth translates into a higher book value which, assuming the company’s P/B ratio stays the same, will
translate into a higher stock price. The risks of owning a growth stock are that earnings, and hence book value,
might not increase as expected or that P/B could decline.

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Growth stocks can be further subdivided into those that display consistent growth in earnings and those that display
significant earnings momentum.1 The former group tends to include high-quality companies that consistently
increase their earnings. The latter consists of stocks that display volatile, but above-average, earnings growth. Both
of these subgroups generally possess high P/E and P/B multiples (which reflect their potential for future earnings
growth) and low dividend yields (which reflect their tendency to re-invest earnings in the business).
Investors and portfolio managers who buy value stocks tend to focus on the company’s share price. In particular,
they look for stocks that are trading at a price that reflects a lower-than-justified P/B ratio. Eventually, they believe,
the market will realize this low valuation and, assuming that the book value remains unchanged, the P/B should
rise, which will translate into a higher stock price. The risks of owning a value stock are that the P/B ratio might not
increase as expected and/or that earnings (and book value) could decline.
Value investors can be grouped into three categories:2
• Investors who focus solely on stocks with low P/B ratios – stocks in this category typically include those of
depressed cyclical companies and companies with low dividend yields and little or no current earnings
• Investors who focus on low P/E ratios, which are typical of stocks in defensive, cyclical, or out-of-favour
industries
• Yield investors who focus on stocks with above-average dividend yields

Market Capitalization The other widely used definition of equity style focuses on the size of the company
as measured by equity market capitalization. The stocks with the smallest market
capitalizations are called small-cap stocks and those with the largest market
capitalizations are called large-cap stocks.

There is no precise definition of what constitutes a small- or large-cap stock; it depends on the country and the
overall market capitalization of the country’s equity market. Based on current market capitalizations, Canadian
small-cap stocks are generally considered to be those with a market capitalization of less than $100 million.
Canadian large-cap stocks are those with a market capitalization exceeding $500 million.

Merging Value, A unified framework for defining equity styles combines the value, growth, and market
Growth, and Market capitalization factors into the four styles shown in Table 3.1.
Capitalization Factors

Table 3.1 | Equity Styles

Price-to-Book (P/B) Ratio

Market Capitalization Low High
Small Small-cap value Small-cap growth
Large Equities Large-cap value Large-cap growth

Individual investors who use styles to pick stocks often practice style diversification, selecting stocks of different
styles to reduce the risk of any single style underperforming over a given period. Many managed equity products,
and in particular mutual funds, however, do have a stated style similar to one of the four shown in Table 3.1,
although there are plenty of mutual funds and managed products that do not invest according to a specific style.

1
Jon Christopherson and C. Nola Williams, “Equity Style: What It Is and Why It Matters,” The Handbook of Equity Style Management (New
Hope, PA: Frank J. Fabozzi Associates, 1995).
2
Christopherson and Williams.

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NON-STYLE-BASED
Bottom-up approaches do not necessarily have to be defined in terms of a specific style. Three other approaches
are pure fundamental, pure quantitative, and pure technical.3 These approaches try to identify the best stocks
regardless of style, size, or any other consideration except, possibly, the stock’s contribution to overall portfolio risk
and diversification.

Pure Fundamental The pure fundamental approach involves an analysis of the company’s historical and
projected financial performance and valuation. This usually involves an in-depth look
at the company’s financial statements, with a focus on earnings growth and cash flow,
as well as the quality of the company’s management and other factors. The decision to
buy or sell a stock is often based on an estimate of the stock’s true value compared with
the stock’s market price. The pure fundamental approach is related to the value style
because stocks are considered for purchase if they are deemed to be inexpensive relative
to an estimate of the stock’s true, or intrinsic, value.

Most full-service investment dealers employ equity analysts who use fundamental analysis to recommend stocks
in a particular economic industry or sector. See Chapters 5 and 6 for a discussion of the methods used by equity
analysts.

Pure Quantitative The pure quantitative approach combines historical fundamental data (earnings,
cash flow, book value, etc.) with a statistical analysis using computer-based models
to identify the best stocks according to pre-specified criteria. Many large investment
dealers employ quantitative analysts who regularly publish a list of recommended stocks
based on their analysis.

Pure Technical The pure technical approach assumes that all known market influences are fully reflected
in market prices and that nothing is to be gained by conducting fundamental analysis.
Technicians analyze historical market action to determine probable future price trends.
Many large investment dealers employ technical analysts who recommend stocks based
on technical indicators. See Chapter 7 for more on technical analysis.

TOP-DOWN APPROACHES
Whereas bottom-up approaches to active investing begins with a focus on the attributes of individual stocks,
top-down approaches begin with an analysis of macro factors. A top-down approach begins with a study of
broad macroeconomic factors before it narrows the analysis to individual stocks. Top-down approaches provide
investors with useful information on the investment environment in general, which is helpful in making decisions
about capital market expectations (a key component of strategic asset allocation). Critics of top-down approaches
suggest, however, that the specific characteristics of individual stocks may be overlooked, leading to missed
opportunities. A top-down approach may be either a macroeconomic approach or a style-based approach.4

3
Frank J. Fabozzi and James L. Grant, “Common Stock Portfolio Management Strategies,” The Theory and Practice of Investment Management
(Hoboken, NJ: John Wiley & Sons, 2002).
4
Fabozzi and Grant.

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MACROECONOMIC APPROACH
The macroeconomic approach (the traditional top-down approach) to selecting stocks begins with macro- and
microeconomic analysis of trends and market forecasts in the global, regional, and national economies. The investor
or portfolio manager then selects industries or sectors with the potential to outperform other sectors given the
expected economic outlook. From each sector, the investor chooses individual stocks, usually large-cap stocks, to
maximize liquidity.
The macroeconomic approach is predicated on the belief that the fortunes of economic sectors ebb and flow in
response to changes in the economic cycle and that the investor or portfolio manager is able to pick the sector most
likely to experience superior growth. Such an investor is likely to be characterized as a sector rotator or market
timer.

STYLE-BASED APPROACH
The style-based approach selects stocks from whichever style is expected to perform best given the analysis of the
large scale factors and capital market factors. At times, this may require a focus on small-cap value stocks, while at
other times it could mean focusing on large-cap growth stocks.

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Figure 3.1 shows the relationships between all categories of equity strategies.

Figure 3.1 | Equity Strategies

EQUITY STRATEGIES

Active Equity Strategies Passive Equity Strategies

Attempts to outperform a Attempts to generate a
benchmark portfolio on a return consistent with the
risk-adjusted basis. expected return on the
benchmark portfolio.

Bottom-Up Top-Down Indexing Buy-and-Hold

Approaches Approaches Tracks the Stocks are held
The focus is on Process begins with performance of a until they need to
individual stocks. a study of macro specific market be sold by the
Selected stocks factors before index. client.
must meet specific narrowing the
forecasted analysis to
risk–return individual stocks.
characteristics.

Style-Based Non-Style-Based Macroeconomics Style-Based Approach

Approaches Approaches Approach Individual stocks are
The focus is on a Involves selecting stocks Begins with a macro and selected in whatever
particular set of stocks. with the best chance of microeconomic analysis style offers the best
These stocks have meeting specific of trends and market opportunity for
similar fundamental objectives. forecasts. Industries or outperformance.
characteristics and sectors are then selected Stocks are selected that
performance patterms. based on their potential have similar
for outperformance. fundamental
Individual stocks are characteristics and
then selected from performance patterns.
within Focus here could be
these sectors. small-cap or large-cap
stocks.

Value and Growth Market Capitalization Pure Fundamental Pure Quantitative Pure Technical
Stock selection focuses Stock selection focuses Initial focus is on Initial focus is on Holds the view that
on price-to-book (P/B) on the size of the historical and historical fundamental stocks trade at their
and price-earnings company as measured projected financial data–earnings, cash intrinsic value, thus
(P/E) ratios, and by market performance and flow, book value, etc. nothing is gained
dividend yields (DY). capitalization. valuation. Computer-based through fundamental
Value stocks: low P/B Selection differentiates In-depth look at models used to analysis. Technical
and P/E, high DY. between small-cap and financials, with a focus identify and select analysis used to
Growth stocks: high large-cap stocks. on earnings growth stocks based on analyze historical
P/B and P/E, low DY. and cash flow. Basis of pre-specified criteria. market action to
stock selection: determine future price
compare intrinsic value trends.
with market price.

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SUMMARY
By the end of this chapter, you will be able to:
1. Describe the steps in the asset allocation process.
• For most individual investors, the asset allocation process involves three strategies: strategic asset allocation,
portfolio rebalancing, and tactical asset allocation.

2. Explain the benefits of asset allocation.

Clients derive the following benefits from using an asset allocation strategy:
• Asset allocation accounts for most of the variation in a portfolio’s long-term returns.
• The strategic asset allocation is designed to be an optimal investment portfolio.
• Asset allocation allows meaningful performance measurement.
• Long-term investment objectives are kept in focus.
• Tactical asset allocation allows for opportunities to realize enhanced returns through successful portfolio
tilting.

3. Identify the key decisions associated with asset allocation.

The establishment of the SAA mix flows from the process itself and requires the following steps:
• Establish client objectives and constraints.
• Specify asset classes eligible for the portfolio.
• Specify capital market expectations.
• Derive the efficient portfolio frontier.
• Find and set the optimal asset mix.
4. Describe the two ways in which a mean-variance optimizer can suggest a strategic asset allocation for
an investor.
• A pure mean-variance analysis requires the investment advisor to include information on capital market
expectations and to estimate a numerical value for the client’s risk tolerance.
• Other optimizers require only a set of capital market expectations as input.
5. Assess the factors in deciding an appropriate rebalancing strategy.
The two most commonly employed dynamic rebalancing strategies are temporal and weight based.
• Temporal rebalancing involves rebalancing a portfolio back to target weights periodically – for example,
monthly, quarterly, semi-annually, or annually.
• Weight-based rebalancing involves setting rebalancing thresholds or trigger points that are a percentage of
the portfolio’s value.

6. Explain the methods used to formulate a strategic or tactical asset allocation.

• Strategic asset allocation methods include: mean-variance analysis, time diversification approach, age
approach, and ad hoc approach.
• Tactical asset allocation strategies are either value-based or cyclical.

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7. Construct an asset allocation for a client.

For most investors, the asset allocation process involves deciding upon a strategic asset allocation (after
reviewing strategies discussed in this chapter), portfolio rebalancing (after reviewing strategies discussed in this
chapter), and tactical asset allocation (after reviewing strategies discussed in this chapter).

8. List the advantages and disadvantages of different investment strategies.

An equity investment strategy can be passive or active.
• An active investment strategy uses expectations about individual securities and the overall investment
environment to build a portfolio that will take advantage of those expectations. If the expectations change,
the portfolio will likely change as well.
• A passive investment strategy, on the other hand, does not lead to portfolio changes when expectations
change.

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EQUITY SECURITIES

4 Equity Securities
Analysis of Equity Securities I: Economic and Industry
5
Analysis
Analysis of Equity Securities II: Company Analysis
6
and Valuation
7 Analysis of Equity Securities III: Technical Analysis

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CONTENT AREAS

Should an Investment Advisor Recommend Individual Equities or Managed Products?

What Are the Characteristics And Features of Equity Securities?

What Are the Canadian and U.S. Equity Markets?

How Does an Investment Advisor Obtain Information About Equity Securities?

LEARNING OBJECTIVES

1 | Identify what factors need to be considered when deciding whether to use individual equity
securities or managed products.

2 | Compare the features of common shares and preferred shares.

3 | Describe the features and trading trends of major stock exchanges.

4 | Discuss the types of equity research produced by various analysts.

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INTRODUCTION
Equity securities, particularly common stocks, are an important part of most investors’ portfolios – history has
shown that over the long term, the return on stocks has exceeded that of bonds. In addition, long-term common
stock returns have consistently outpaced inflation, providing long-term protection from a loss of purchasing power.
Investment advisors therefore tend to recommend an allocation to common stocks for investors who need long-
term growth and inflation protection.
This chapter is the first of four dedicated to helping investment advisors choose individual equity securities for
their clients. It starts with a discussion of the factors that lead advisors and their clients to choose individual equity
securities instead of (or in combination with) managed products. The chapter then reviews some of the basic
features of common shares and preferred shares before reviewing Canadian and U.S. equity markets. The chapter
concludes with an introduction to the types of research and information sources investment advisors can use to
help clients select stocks.

SHOULD AN INVESTMENT ADVISOR RECOMMEND INDIVIDUAL

EQUITIES OR MANAGED PRODUCTS?
After agreeing on how much to allocate to equities, the investment advisor and the client will select an investment
strategy or strategies that will be used to select securities for the client’s equity asset class or classes.
Adoption of a passive strategy for some or all of the equity asset class makes the choice of securities easier; in most
cases, the investment advisor will recommend an index-linked managed product, such as an exchange-traded fund
or indexed mutual fund. The client and advisor face a much harder decision, however, when they have chosen an
active investment strategy.
With an active strategy, the first decision the investment advisor and client must make is whether to use managed
products or individual securities such as common or preferred shares. This does not have to be an all-or-nothing
choice. An advisor may recommend a managed product for a portion of the equity allocation and individual equity
securities for the remainder. Whatever the advisor recommends, it must always be in the client’s best interest.
Investment advisors and their clients need to consider several factors when deciding between individual securities
and managed products:

The client’s willingness This is by far the most important factor in the decision. Some clients are uncomfortable
to invest in individual with the idea of buying stocks, believing that individual equity securities are too risky.
equity securities Even if the investment advisor determines that the client is able to invest in individual
equity securities based on the size of the client’s portfolio and his or her investment
objectives and constraints, the client may simply refuse to do so. If the advisor thinks
that it is in the client’s best interest to invest in individual equity securities then the
advisor must educate the client on the potential benefits and hope that the client will
eventually agree. If the client does not agree, the advisor will have to implement the
equity allocation using managed products.

The dollar value Generally, managed products are more appropriate when the dollar value allocated to
allocated to equities equities is small and the need for diversification is high. One of the biggest advantages of
and the need for managed products such as mutual funds is the ability to invest in a diversified portfolio
diversification of investments with a small initial investment.

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The investment Investment advisors are not equity analysts, so their ability to recommend individual
advisor’s access to equity securities is directly related to their access to timely, accurate research. Most
timely, accurate advisors rely on research from in-house or third-party equity analysts and strategists.
research on individual Advisors must be confident that these research tools will allow them to recommend
equities appropriate equity portfolios for their clients. In addition, advisors need to know not
only what securities to buy, but also what and when to sell. Most advisors in Canada
have ready access to research on North American equities, although the timeliness
and accuracy of the recommendations varies. The availability of research on non–
North American equities is much more limited. Investment advisors therefore often
recommend individual equities for Canadian and U.S. allocations and managed products
for any non–North American equity allocation.

The desire to control Although timing may not influence the initial decision to invest in managed products
the timing of taxable or in individual equities, it can affect subsequent decisions when new money is being
transactions invested. When buying equity-based managed products, investors cannot control the
timing of realized capital gains because in almost all cases investors will receive a capital
gains distribution at the end of each year, even if they have not sold any units in the
fund during the year. The capital gains distribution represents net trading gains earned
by the fund during the year and is paid to investors to avoid taxation of the fund. With
individual equity securities, investors have complete control over the timing of taxable
transactions; as long as the investor does not sell the securities, no taxable capital gain
(or allowable capital loss) results.

The factors above are only four of the many issues investment advisors and their clients need to consider. In the end,
the client has the final say; all the advisor can do is suggest what he or she thinks is best for the client and explain
the advantages and disadvantages of the alternatives.
If the investment advisor and client decide to use individual equity securities for any portion of a client’s portfolio,
the advisor must be ready to recommend securities for purchase or sale at any time during the advisor-client
relationship. To do this, the advisor must fully understand the characteristics and features of the different types of
equity securities.

WHAT ARE THE CHARACTERISTICS AND FEATURES OF EQUITY

SECURITIES?

COMMON SHARES
Common shares are issued by a corporation and represent ownership interest in the corporation. Investors who
own common shares are referred to as the corporation’s common shareholders. Corporations issue common
shares to:
• Raise capital
• Pay dividends without using cash by issuing stock dividends
• Buy other companies without using cash
• Meet the obligations of a convertible security (for example, if the corporation has issued a convertible bond,
it will issue common shares whenever convertible bondholders decide to convert their bonds into common
shares)

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VOTING PRIVILEGES
Common shareholders generally have one vote per share. Voting takes place at the company’s annual general
meeting, at which, among other things, the company’s board of directors is elected. Voting may also take place
at special shareholder meetings, which are called so shareholders can vote on specific issues, such as a proposed
takeover.
Shareholders do not need to attend shareholder meetings to vote on company matters. Voting can be done by
proxy. A proxy provides a shareholder with information on the matters being voted on and a form to register the
vote. For example, to vote for a director, a shareholder completes the proxy by stating whether the shareholder
is “for” or “against” the election of each nominee. After indicating a vote on all (or some of) the issues, the
shareholder submits the proxy to the company’s management, which submits the votes on behalf of the
shareholder at the meeting.
Not all common shares give shareholders one vote per common share. Some companies issue multiple voting,
restricted voting, subordinated voting, or even non-voting common shares.
• Non-voting common shares are common shares with no voting privileges. Most non-voting shares, however,
give shareholders limited voting rights or full voting rights under certain circumstances.
EXAMPLE
Holders of Canadian Tire’s Class A non-voting shares are entitled to elect three directors.

• Restricted voting common shares limit the number or percentage of votes available to holders of common
shares.
• Subordinated voting common shares are common shares of a corporation that have fewer voting rights per
share than does another class of common shares.
EXAMPLE
Bombardier Inc. has two classes of common shares: Class A and Class B. Class A shares entitle holders to 10 votes
per share; Class B subordinated voting shares entitle shareholders to one vote per share.

• Multiple voting common shares entitle shareholders to more than one vote per share. The Bombardier Class
A shares are an example. In most cases, the company’s founding family owns the majority of a company’s
multiple voting shares, effectively giving the family control of the company. For this reason, trading activity in a
company’s multiple voting shares is usually lighter than that of the company’s subordinated voting shares.

DIVIDEND POLICY
Some companies pay dividends to their common shareholders and some do not, though even companies that pay
dividends are not obligated to do so. Each quarter, a company’s board of directors decides whether the company will
pay dividends, the amount of the dividend, and the payment date. Companies that pay dividends generally continue
paying them, and many increase the amount of the dividend regularly. Shareholders generally react negatively when
a company cuts its dividend, or worse, stops paying dividends altogether. Except in rare circumstances, the reaction
to such a decision is usually a decline in the share price.
Shareholders of record on the dividend record date receive dividends on the payment date. Because stock trades
settle two business days after the trade date (known as “T + 2” settlement), stocks begin to trade ex-dividend
on the first business day before the record date. If a stock is trading ex-dividend, it means that the buyer will not
receive the declared dividend for shares traded on or after this date.

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Dividends are generally classified into three categories:

1. Regular dividends are those that investors can expect to receive on an ongoing basis unless the company
experiences a significant reduction in earnings or a large loss. As noted above, companies can reduce or
eliminate their regular dividends at any time.
2. Extra dividends are those that may be paid because of unusually favourable circumstances and may not be
repeated. Extra dividends are normally paid by companies that have a lot of cash on hand and no opportunities
to invest in ongoing or new business ventures.
3. Stock dividends are paid in the form of additional common shares rather than cash. Stock dividends allow the
company to preserve its cash for internal use. Since additional stock is issued, the use of stock dividends dilutes
a company’s earnings per share.

Firms that pay large dividends include well-established companies in mature industries. Such companies usually
have relatively stable and sustainable earnings, access to external financing, and few opportunities for rapid growth.
In contrast, small or rapidly growing firms tend not to pay dividends or to pay small ones. These firms are generally
not producing large profits, may have difficulty obtaining external financing, or may prefer to reinvest profits back
into the firm.

DIVIDENDS VERSUS SHARE REPURCHASE

The choice to either initiate/increase dividends (or pay an extra dividend) to common shareholders and/or to
repurchase common stock is referred to as the company’s payout policy.
According to industry-leading finance theoreticians Miller and Modigliani, a company’s value is derived directly from
its cash flow generating capability. The amount of cash flow that can be paid out to its equity investors is directly
dependent on its free cash flow. Given the perfect capital market conditions assumed by the theoreticians, it follows
that the value of a company is not dependent on whether the payout of free cash flow (FCF) is done via dividends or
common share repurchases.
However, the imperfections that are present in today’s capital markets do have an effect on a company’s payout
policy decisions. These market imperfections include:

Income tax Income taxes, especially from the shareholder’s perspective, are a key ‘imperfection’ that
efficiency influences management’s payout policy. First, dividends are paid out of after-tax profits at
the company level. The distribution of these profits in the form of dividends will result in
them being taxed again, this time in the hands of the investor. This is commonly referred to
as double taxation and raises the question as to whether dividends are the optimal method
of distributing FCF to investors. Second, in comparison to capital gains, dividend payments
are generally less tax-efficient for individual investors since the income tax rate is higher for
dividends than capital gains. Additionally, there is the benefit of the time value of money
since income taxes on dividends must be paid by the investor in the tax year they are
received, whereas capital gains on the investor’s stock holdings are deferred until the time
the stock is sold.

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Investor effects Every publicly-traded company has a different mix or proportion of investor types. Each
of these broad types of investors have different respective income tax situations and will
accordingly have a strong preference for the payout policy that results in the highest after-
tax return for them. This unique investor-type mix can influence a company’s payout policy.
The two main investor types and their respective payout policy preference are as follows:
• Institutions, pension plans and individual retirement accounts: These types of investors
are generally tax-advantaged and do not pay income taxes on any and all types of
income received. Since they have no tax preference, they will prefer the payout policy
that is most closely aligned with their cash flow needs.
• Individual investors: Individual investors find dividends to be tax disadvantageous and
therefore have a preference for a common share repurchase-type of payout policy.

Management Company management usually has a preference for share repurchase payout policies
incentives since share repurchase activity reduces the number of shares outstanding and accordingly
increases the earnings per share (given a fixed amount of total corporate profits). This is
therefore supportive of management performance measures that are based on “per share”
metrics such as earnings per share.
A second, but implicit benefit of share repurchases to management is that it can partially or
totally offset the dilutive impact of common share option grants that are exercised over time.

Management It is generally recognized by capital market participants that company management has
signals superior knowledge regarding the present and future financial situation of the company,
and therefore it is assumed that a company’s payout policy reflects management’s effort to
maximize the value of the company. In this case, share repurchases are often viewed by the
market as a signal that management feels the share price is currently undervalued and share
repurchases benefit remaining shareholders (who often include management).

Company management must therefore take into account the four main factors noted above when deciding their
payout policy.

PREFERRED SHARES
Preferred shares also represent an ownership interest in the issuing company. Preferred shares are characterized by
their par value and dividend rate. Preferred shareholders have a claim on the company’s assets equal to the shares’
par value. That is, if a company that has common shares and preferred shares outstanding, and has no debt, were
to wind up its operations, preferred shareholders would be entitled to receive only the par value of their shares
(provided there are enough assets to make this possible). Common shareholders would be entitled to whatever,
if anything, was left over.
Preferred shareholders are usually entitled to a fixed dividend payment subject to the discretion of the board of
directors. Some preferred share dividends are cumulative, which means that dividends that are not paid out accrue
and must be paid before the company pays a dividend on its common shares.
As long as dividends are paid to preferred shareholders as scheduled, these shareholders have no voting rights.
But if a stated number of dividend payments are omitted, then the preferred shares receive voting privileges. In
addition, as long as the company remains solvent, preferred shareholders have no claim to the residual income of
the corporation beyond their preferred dividends (in other words, the dividend rate is fixed). The residual income
belongs to the corporation’s common shareholders.

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Because of their fixed claim on company assets and their fixed dividend, preferred shares are sensitive to interest
rates. They tend to fall in value when interest rates go up and rise in value when interest rates go down. As a result,
preferred shares are considered more like a debt security than an equity security and are sometimes included in a
client’s allocation to debt securities.

WHAT ARE THE CANADIAN AND U.S. EQUITY MARKETS?

CANADIAN STOCK MARKETS

There are five stock exchanges in Canada, three of which are owned by the TMX Group:
• The Toronto Stock Exchange (TSX)
• The TSX Venture Exchange, including NEX (see below)
• The Canadian Securities Exchange (CSE)
• Alpha Exchange
• Aequitas Neo Exchange

In Canada, securities of what are generally referred to as senior issuers are listed on the Toronto Stock Exchange.
Securities listed on the TSX consist mostly of common shares, with some preferred shares, real estate investment
trusts, and a limited number of debentures.
Securities of junior issuers are listed on the TSX Venture Exchange. These companies are mainly emerging firms. If a
company in this category grows successfully, it can obtain a listing on a senior exchange such as the TSX.
Companies are classified as senior or junior based on factors such as the company’s tangible assets, cash on
hand, and profitability. Compared with senior issuers listed on the TSX, junior companies listed on the TSX
Venture Exchange are not required to have as many tangible assets, as much cash on hand, or the same degree of
profitability.
Companies that fall below the TSX Venture Exchange’s listing standards can trade on NEX. NEX is a separate board
of the TSX Venture Exchange. Companies that were formerly listed on the TSX or TSX Venture Exchange are eligible
to list on NEX.
The NEX listing allows companies to maintain a listing within the TMX Group as they work on improving their
business prospects. A NEX listing also allows investors to continue trading these companies’ shares.
The Ontario Securities Commission recognizes the company that operates CSE, CNSX Markets Inc., as a stock
exchange. CSE positions itself as a low-cost alternative to “traditional stock exchanges”. As of June 2017, over
300 securities were listed on the CSE. Securities listed on the CSE are mainly common shares along with some
government bonds and structured products. Currently, all securities listed on the TSX and TSX Venture Exchange can
be traded on the CSE.
Alpha Exchange, which is owned by the TMX Group, is an exchange which trades TSX and TSX Venture Exchange
listed securities.
Aequitas NEO Exchange is an exchange that provides listing services and facilitates trading in securities listed on
Aequitas NEO, TSX and TSX Venture Exchanges.

U.S. STOCK MARKETS

The New York Stock Exchange is arguably the most recognized stock exchange in the world. There are over 2,300
mid- and large-capitalization companies on the NYSE. Canadian companies such as Barrick Gold interlist their
common shares on both the NYSE and the TSX.

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In addition, some non-U.S. issuers list American Depositary Shares (ADSs) on the NYSE. (The term American
Depositary Receipt – ADR – is sometimes used interchangeably with ADS. Technically, an ADR is the certificate that
represents ownership of the underlying company’s shares, whereas an ADS is the security that is actually traded.)
An ADS is a security issued by a U.S. depositary (usually a trust company) representing ownership interest in the
securities of a foreign company. The relationship between the price of the ADS and the price of the issuer’s securities
on its home exchange depends on the exchange rate and on how many of the issuer’s underlying securities are
represented by each ADS (it can be one, more than one, or less than one).
Companies issue ADSs to increase the marketability of their shares to investors trading on U.S. exchanges.

EXAMPLE
Finnish mobile communications company Nokia lists an ADS on the NYSE. Each Nokia ADS has an underlying
interest of one Nokia common share. Investors can purchase Nokia shares directly on NASDAQ OMX Nordic, but
some investors, particularly those in North America, will likely find it cheaper (in terms of transaction costs) to
buy Nokia’s ADSs on the NYSE.

The NASDAQ lists over 3,100 companies. Stocks listed on the NASDAQ range from start-ups to large, well-
established companies, such as Microsoft and Intel.

RECENT TRENDS IN TRADING

There has been a strong movement away from the traditional market maker or specialist trading model of years
past toward more anonymous electronic trade execution. With the traditional model, large orders were difficult
to hide, resulting in market impact – sale prices that are lower or purchase prices higher than the market just prior
to trade entry. Since institutional trading accounts for a very large and growing share of stock market activity in
Toronto and abroad, institutional money managers began seeking ways to reduce market impact.
As computer technology increased the speed of trade executions and sent commission costs plummeting,
institutional funds began directing more orders through alternative trading systems (ATSs). An ATS is an off-
exchange private electronic network that discreetly and directly matches buyers and sellers using a computer
program. There are no intermediaries. Large orders can be executed with little or no market impact.
Traditional exchanges have long been losing business to the ATSs while at the same time profitability has been
squeezed by reduced commissions. The NYSE and TSX have countered these trends by spending millions of dollars
upgrading their technology to compete with the ATSs.
In Canada, the development of an ATS network has been far slower than it has been in the United States. Only
since 2001 has the regulatory framework existed for the creation of an ATS market (in contrast, Instinet has been
operating in the United States since 1969).
As of November 2016, securities regulators in Canada have recognized each of Bloomberg Tradebook Canada
(“Bloomberg”), Nasdaq CXC Limited (currently operates the Nasdaq CXC/Nasdaq CX2/Nasdaq CXD trading
facilities), Instinet Canada Cross (“ICX”), Liquidnet Canada, MATCH Now (operated by TriAct Canada), Omega ATS
and Lynx ATS as an equity ATS. IIROC regulates these Canadian ATSs.

HOW DOES AN INVESTMENT ADVISOR OBTAIN INFORMATION

ABOUT EQUITY SECURITIES?
Investment advisors must become familiar with the characteristics of the securities and investments they
recommend to their clients, usually by reading research provided by their firms or by reading or hearing information
about companies in the media.

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EQUITY RESEARCH
The first place investment advisors go for ideas about which stocks to buy and sell is the research on Canadian
markets and companies provided by their employers. Research on U.S. markets and companies is usually purchased
from a U.S. dealer. Some advisors like to know what other investment dealers are saying about the stocks they
cover, so most dealers monitor other dealers’ research and provide their advisors with high-level summaries,
including changes to recommendations and price targets. Some investment advisors also use contacts within the
industry to obtain full research reports produced by other Canadian dealers.
Regardless of its source, research relevant to the stock selection process is prepared by individuals who hold one or
more of the following titles:
• Investment strategist
• Equity analyst
• Economist
• Quantitative analyst
• Technical analyst

INVESTMENT STRATEGISTS
Investment strategists, also known as market strategists, portfolio strategists, or just strategists, analyze
and comment on a wide variety of investment themes, including asset allocation, market valuation and forecasts,
sector/industry analysis, and individual stock selection. Their reports and articles – of varying length and detail –
often combine original research with the work of their firm’s economists and analysts. Strategists’ reports typically
include plenty of graphs, charts, and tables to help get the message across.
In the area of stock selection, most investment strategists maintain a recommended list of best stock picks.
Strategists perform a valuable function by summarizing and organizing the research of many analysts into these
lists. Investment advisors frequently use the lists to recommend stocks to their clients.
The stocks on recommended lists may be grouped by sector and risk, which can help investment advisors determine
which stocks are appropriate for specific clients. For example, a recommended list might sort stocks in, say, the
technology sector into low-, average-, or high-risk categories. If an investment advisor and client determine that
they want to add a technology stock to the client’s portfolio, they can pick a technology stock from the risk level
appropriate for the client’s present situation. The stocks on a recommended list might also be grouped by style
classification, such as small- and large-capitalization growth and value stocks, or by sensitivity to the economic
cycle, such as defensive or cyclical stocks.

EQUITY ANALYSTS
Most Canadian investment dealers employ a team of equity analysts, also called research analysts, company
analysts, or just analysts. Equity analysts use fundamental analysis to estimate the return and risk of an investment
in the common shares of the companies in their coverage universe, which is normally a specific industry or sector.
For example, a gold analyst covers only companies involved in the exploration for and mining of gold. Firms may
also have a technology analyst, a forest products analyst, and so on.
Investment dealers and their analysts are under no obligation to cover all companies that operate within a particular
sector or industry, and in fact they rarely do. In most cases, equity analysts in Canada research well-known mid- to
large-capitalization stocks. A few cover smaller-cap stocks – and this area has received more attention in the past
decade – but the number of small-cap stocks covered by analysts is significantly smaller than the number of mid-
and large-cap stocks covered. This tendency to focus on larger companies and ignore smaller ones is often cited as a
reason why small-cap stocks outperform large-cap stocks.

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To estimate the return and risk of a stock, equity analysts perform industry analysis, company analysis, and equity
valuation. Industry analysis involves researching, analyzing, and forecasting the factors that contribute to or detract
from the success of all companies within the industry and determines which companies are positioned to perform
better than others in the industry. Although equity analysts are concerned primarily with analyzing the industry
or sector defined by their coverage universe, the term industry analysis is also used to describe a comparison of
one or more industries to determine which could outperform others. This latter function is normally carried out by
investment strategists. Company analysis also involves research, analysis, and forecasting, but the focus is on an
individual company rather than the industry as a whole.
Using the results of industry and company analysis, equity analysts try to determine the true, or intrinsic, value of
a stock. When the forecast intrinsic value is compared with the market price of the stock, analysts may deem the
shares to be mispriced. In this case, analysts usually assume that the stock will eventually trade at its intrinsic value,
and will establish a target price for the stock over some future investment horizon, usually one year. The target price
establishes the maximum potential return from owning the stock.
The potential return is used to place the company’s shares in one of the dealer’s ratings categories, each of which
represents a statement about the expected return on the stock relative to all the stocks in the analyst’s coverage
universe. For example, a dealer may use a system in which analysts assign one of three generic ratings to the
companies they cover, such as sector outperform, sector perform, and sector underperform (the actual names used
by a dealer may be different).
• A sector outperform rating indicates that the expected return on the shares is greater than the expected return
on the shares of other companies in the analyst’s coverage universe.
• A sector perform rating indicates that the expected return is about the same as the expected return on the
shares of other companies.
• A sector underperform rating indicates an expected return lower than that of other companies.

Along with the expected return rating, the analyst will estimate the risk associated with the stock, usually expressed
as low, medium, or high, or some variation of these categories.
Chapters 5 and 6 explain industry analysis, company analysis, and equity valuation in more detail.

ANALYST SCANDALS AND THE RESPONSE OF CANADIAN REGULATORS

Rating company shares relative to the shares of other companies in the analyst’s coverage universe is a relatively
new way of recommending stocks. Investment dealers in both Canada and the United States changed their rating
systems and the way they communicate recommendations to investors in response to some well-publicized
scandals involving high-profile equity analysts in the United States during the technology “bubble.”
In the past, dealers and analysts used three basic ratings, “buy,” “hold,” and “sell,” although some firms used vague
terms such as “accumulate” and “market perform.” This system might have survived the scandals had it not been
for the fact that in the past, dealers and analysts rarely, if ever, assigned a “sell” rating to the companies they
covered. This lack of willingness to say “sell” when the analyst really meant “sell” was at the heart of a much bigger
conflict-of-interest problem.
Most investment dealers that produce research also provide investment banking services to the companies they
research. Investment banking services include helping companies raise money by issuing securities and advising
companies on mergers and acquisitions. Dealers make a lot of money providing investment banking services and
practically nothing producing research. As a result, dealers were hesitant to assign a “sell” rating to a company’s
shares for fear of damaging any future investment banking relationships with that company.
Securities regulators in the United States and Canada instituted policies that set stringent restrictions and disclosure
requirements for dealers who publish research and recommendations and the analysts who perform the research
and make the recommendations. The policies do not prevent dealers from issuing research reports on companies to

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which they provide investment banking services, but they do attempt to remove the conflict of interest and increase
the amount of disclosure in research reports.

INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA (IIROC) RULE 3400

Rule 3400 sets out a list of restrictions on IIROC dealer members and their analysts and requires increased
disclosure in their research reports. The policy also includes guidelines that, while not strictly required, are expected
to be followed. The entire policy is available on IIROC’s website, www.iiroc.ca.
Among other things, Rule 3400 requires IIROC dealer members to:
• Have written policies and procedures in place to control potential conflicts of interest that may arise in the
preparation and publication of research.
• Disclose in their company research reports whether they have provided any investment banking services to
the company in the previous 12 months. If the dealer member acts as manager or co-manager for an initial or
secondary offering of the company’s securities, the dealer member cannot publish a report on the company for
10 calendar days following an initial offering or for 3 calendar days following a secondary offering (unless the
report is concerning the effects significant news about or a significant event affecting the issuer within these
timeframes).
• Ensure that recommendations are not influenced by the investment banking department or the company that is
the subject of a report.
• Disclose in their company research reports whether the dealer member or any partner, director, officer, or
analyst involved in the preparation of the report has provided services to the company in the past 12 months,
and whether a partner, director, officer, or employee of the dealer member serves in any advisory capacity to
the company.
• Disclose their system for rating securities, how each recommendation fits within the system, their policies on
the dissemination of research, and the methods used to set price targets in their company research.
• Disclose whether an analyst or associate directly involved in the preparation of a company report owns or is
short any of the company’s securities directly or through derivatives.

Rule 3400 also restricts IIROC dealer members from certain conduct including:
• Issuing a company research report prepared by an analyst if either the analyst or the analyst’s associate(s)
serves as an officer, director, employee, or in any advisory capacity to the company.
• Issuing a favourable research recommendation or price target in return for direct compensation from the
company or as consideration for business from the company.
• Allowing their analysts or associates directly involved in the preparation of research to trade contrary to their
current recommendations, unless special circumstances exist.
• Allowing their analysts or associates directly involved in the preparation of research to trade in a security of
the company or a derivative based on a security of the company for 30 calendar days before the publication
of a report and 5 calendar days afterwards unless that individual receives the previous written approval of a
designated partner, officer, or director of the dealer member.

ECONOMISTS
Generally, economists research, collect, and analyze economic data; monitor economic trends; and develop
economic forecasts. Although economists do not generally make recommendations to buy or sell specific stocks,
securities markets are tied to the overall performance of the economy; fundamental equity analysts, market
strategists, and, ultimately, investment advisors use economic analysis to make stock selection decisions.

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Economists working for investment dealers focus on producing research that will ultimately be helpful in the
stock selection process. The branch of economics most relevant to the stock selection process is known as
macroeconomics, which is concerned with data and trends in the overall economy. The macroeconomic variables of
most interest include those related to economic growth, employment, inflation, and interest rates.

QUANTITATIVE ANALYSTS
Some of the larger investment dealers employ quantitative analysts, who combine historical fundamental data
with statistical analyses using computerized models to identify the best stocks according to specified criteria.
Quantitative analysts may also publish research and recommendations related to asset allocation.
Sometimes it can be difficult to distinguish between the analysis produced by a quantitative analyst and that
produced by an equity analyst. For example, both study companies’ annual and interim reports. Quantitative
analysis, however, deals only with measurable factors in the reports (the financial statement numbers, for
example), not with factors such as the quality of company management, information that can be gleaned from the
Management’s Discussion and Analysis section in a company’s interim and annual reports to shareholders.
From an investor’s perspective, however, it could be argued that most of the relevant information about the
quality of a company’s management is reflected in the company’s financial results, especially profit growth over
the long term. Furthermore, quantitative analysts argue that if the qualitative aspects of fundamental equity
analysis deal only with matters that cannot be precisely measured, then conclusions and recommendations are, by
definition, subjective and potentially arbitrary. Quantitative analysis, by comparison, is expected to be objective,
mathematically based, and scientific.
Quantitative methodologies, correctly applied, can improve the investment decision-making process using
statistical analysis, computing power, and data from very long periods. Any thorough quantitative framework should
be based on in-depth objective testing of historical data on dozens, even hundreds, of investing styles. As the world
becomes more scientific and sophisticated, quantitative methods are quickly becoming more widely accepted.

TECHNICAL ANALYSTS
Technical analysis is the process of analyzing historical market action to determine probable future price trends.
Market action encompasses the three primary sources of information available to a technical analyst: price, volume,
and time.
While the number of technical analysts employed by investments dealers is small compared with the number of
fundamental analysts employed (some investment dealers do not employ any technical analysts), technical analysis
is a popular tool used to varying degrees by almost all investment advisors. Chapter 7 examines some technical
analysis tools in greater detail.

PRINT MEDIA AND TELEVISION

Although research reports are an investment advisor’s primary source of information about which stocks to buy and
sell, advisors use print media and television to keep abreast of recommendations produced by analysts, strategists,
and portfolio managers at other firms. Most investment advisors regularly read the business sections of Canada’s
two national daily newspapers, The Globe and Mail and the National Post, both of which cover the markets and
other financial matters. Many Canadian investment dealers also summarize for their advisors the lead stories in U.S.
business newspapers such as The Wall Street Journal, Barron’s, and Investor’s Business Daily.
Investment-related magazines and periodicals are another source of information for investment advisors. Canadian
magazines such as Investment Executive and Advisor’s Edge are specifically targeted to investment advisors and
are dedicated to covering hot topics and trends relevant to advisors and their clients. These magazines also host
websites offering additional information and resources.

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Another source of information for investment advisors is business television. Entire channels exist that are
dedicated to covering the markets and financial matters. These channels have become so popular in the investment
community that it is rare to find an investment advisor with access to a television who is not constantly tuned to
one of these channels. CNBC is by far the most popular business channel in the world. Canada’s BNN (Business
News Network) is widely followed. These channels offer news coverage as well as interviews with analysts,
economists, strategists, and portfolio managers.

THE INTERNET
A growing source of information on stocks is the Internet. A number of websites offer free or fee-based analysis and
tools. Free sites include those offered by issuers (companies), stock exchanges, the media, and Internet portals such
as Yahoo! Fee-based sites include those offering specialized research and analysis.
While the Internet offers a wealth of information, investment advisors should always consider the source of the
information and are well advised to take information and analysis from anything but the most reliable sources with
a grain of salt. As always, if something looks too good to be true, it probably is.

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 CHAPTER 4 | EQUITY SECURITIES 4 • 15

SUMMARY
By the end of this chapter, you will be able to:
1. Identify what factors need to be considered when deciding whether to use individual equity securities or
managed products.
• The client’s willingness to invest in individual equity securities.
• The dollar value allocated to equities and the need for diversification.
• The investment advisor’s access to timely, accurate research on individual equities.
• The desire to control the timing of taxable transactions.
2. Compare the features of common shares and preferred shares.
• Common shares are issued by a corporation and represent ownership interest in the corporation.
• Preferred shareholders have a claim on the company’s assets equal to the shares’ par value. Because of their
fixed claim on company assets and their fixed dividend, preferred shares are sensitive to interest rates.

3. Describe the features and trading trends of major stock exchanges.

• There are four stock exchanges in Canada, three of which are owned by the TMX Group.
• The New York Stock Exchange and the NASDAQ both have over 2,000 listings.
• There has been a strong movement away from the traditional market maker or specialist trading model of
years past toward more anonymous electronic trade execution.

4. Discuss the types of equity research produced by various analysts.

• Regardless of its source, research relevant to the stock selection process is prepared by individuals who hold
one or more of the following titles: investment strategist, equity analyst, economist, quantitative analyst, and
technical analyst.

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 Analysis of Equity Securities I:
Economic and Industry 5
Analysis

CONTENT AREAS

What Is Economic Analysis?

How Does An Investment Advisor Use Economic Analysis When Developing Strategic and Tactical
Investment Strategies?

What Are Economic Forecasts?

What Are Key Economic Metrics?

What Is Industry Analysis?

LEARNING OBJECTIVES

1 | Describe how economics drives the development of investment strategies.

2 | Describe how economic forecasts are created.

3 | List key economic metrics.

4 | Explain how international economic events affect an economic forecast.

5 | Explain how industry analysis is used.

6 | Describe the ways industries are classified.

7 | Identify the ways industry characteristics affect profitability.

8 | Apply economic and industry analysis.

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INTRODUCTION
Before recommending the purchase or sale of equity securities, investment advisors should establish a view on the
outlook for the overall economy and the industries in which companies operate. In most cases, this view will be
based on economic and industry analysis carried out by economists and equity analysts at the investment advisor’s
firm.
The first half of this chapter examines how economic analysis is applied to the process of making investment
decisions. The role of economic analysis in strategic and tactical asset allocation is explained, and the distinction
between cyclical trends and secular trends is described. The factors that go into a typical economic forecast are then
identified, and the role of consensus forecasts in determining how the market reacts to the release of economic
information is considered. This is followed by a closer look at the key statistics that market participants track. The
section concludes with a discussion of international economic developments and events.
The second half of the chapter focuses on industry analysis. The overview of the importance of industry analysis is
followed by a discussion of how industries can be classified according to the product or service they produce, their
stage in the industry life cycle, or their reaction to the economic cycle. The key industry characteristics that equity
analysts monitor are identified, and the chapter concludes with a discussion of how to use industry analysis in
sector rotation.

WHAT IS ECONOMIC ANALYSIS?

OVERVIEW
For all investors, from the most conservative to the most aggressive, the rationale for many investment decisions
ultimately rests on their view of the economy as a whole. This view consists of a set of assumptions about economic
variables or events that affect economic growth, inflation, and, ultimately, corporate profitability. For many
investment advisors and their clients, the view they take is based on forecasts developed by economists working for
the same firm.
To better assess the impact of economic events on market direction, advisors must first understand the components
of this view, the factors that shaped it, and the way in which unfolding events and developments confirm or
contradict the view. Unfortunately, economic data is often ambiguous and is interpreted differently by various
market participants, such as traders, brokers, or economists.

HOW DOES AN INVESTMENT ADVISOR USE ECONOMIC ANALYSIS

WHEN DEVELOPING STRATEGIC AND TACTICAL INVESTMENT
STRATEGIES?
The typical day for an investment advisor begins with a morning meeting or conference call, during which traders,
institutional salespeople, and investment advisors come together with the firm’s economists, strategists, and
analysts to discuss the firm’s proprietary positions, significant block trades in the market, and any other information
relevant to the trading day. Usually, these meetings start off with an economics overview that focuses on three
key areas:
• How markets have reacted to economic news released since the last meeting.
• Critical events and data from the overnight trading session.
• A preview to the day’s agenda.

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Most participants at the meeting are aware of some, if not all, of the events and data under discussion. What
economic research contributes is an analysis of these events and data that results in a change in the economics
department’s forecast of a particular variable or of overall macroeconomic projections.
Before the creation of business news networks such as CNBC and before the media spent as much time as it
does now on market watching, investors had more difficulty getting economic information and market impact
assessment. This lack of information gave investment dealers, fund managers, and other larger-scale investors a
relative advantage. Today, investors have access to much of the information available to institutions, although that
has not altered the importance of in-house economic research. In fact, today’s market participants are so inundated
with information that the quality of the analysis is even more important; investors must sort out useful information
from misleading or worthless information.

STRATEGIC AND TACTICAL INVESTMENT STRATEGIES

The difference between strategic and tactical asset allocation is:

Strategic asset Is the asset mix established to meet an investor’s long-term goals based on the client’s
allocation objectives and constraints as well as long-term capital market expectations.

Tactical asset Involves deviating from the strategic asset allocation to profit from short-term
allocation expectations about the relative performance of the various asset classes.

Economic information and analysis is used differently for each type of asset allocation. Strategic trading involves
establishing and maintaining a portfolio’s strategic asset allocation. Because the strategic asset allocation is a long-
term asset mix, strategic trading tends to be infrequent. Tactical trading, on the other hand, involves the shifting of
positions or portfolio allocations in reaction to or in anticipation of the day-to-day release of economic information.
Certain economic variables are more relevant than others to the performance of a security. At the same time, some
indicators (such as the U.S. unemployment report) can affect the market as a whole and, in turn, influence an
investor’s decision about a specific security.
Unfortunately, the media does not always explain what is behind the numbers reported. Media sound bites tend
to be superficial and often miss the most interesting or meaningful aspects of the particular event or data release.
For example, the media may report that retail sales are strong, without explaining whether this strength is the
result of outstanding performance in just a few categories or good performance in a broad range of categories.
The economist’s role is to take a closer look at the numbers and brief investment advisors and their clients on the
broader implications for specific sectors of the economy and forecasts.
Market participants sometimes use the word noise when discussing certain economic releases, which means
ambiguous messages from a single report or mixed readings from a series of releases. Noisy data can hide the real
direction of an underlying variable or of the economy in general. Economists use many tools to filter out the noise,
including seasonal adjustments, moving averages, and trend analysis.
Short-term fluctuations in the data may provide investors with tactical trading opportunities as market participants
react to monthly changes in the data. It is important, however, to be aware of long-term trends to properly position
the strategic asset allocation mix.

SEASONAL ADJUSTMENTS
Many economic indicators tend to change fairly predictably in certain time periods, whether quarterly, monthly,
or on a specific day in a month. An obvious example is the performance of retail sales during the weeks before
Christmas. Companies in certain sectors also exhibit seasonality in their earnings, performing more strongly in
winter than in summer, or vice versa.

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Seasonal movements may be large enough to mask important information of interest to economists and investors.
To analyze an indicator independent of seasonal movements, economists adjust the data by isolating the time
periods that have the most influence on changes in the variable and adjusting the time series of the variable so that
the effect of seasonality is either removed or minimized. The data can then be compared to other months in which
seasonal influences are less severe. Many economists and investors prefer seasonally adjusted data because they
want to see characteristics that seasonal movements tend to mask, such as changes in the direction of a variable.

MOVING AVERAGES
If an indicator displays excessive volatility that cannot be explained by seasonality, a smoothing technique known
as a moving average is used to average the values of the indicator over specific periods. The greater the number of
periods chosen, the more variability will be removed from the time series.

TREND ANALYSIS
If an economist uses a sufficiently large number of periods in a moving average adjustment, it is possible to identify
a longer-term trend for the indicator. Traditional trend analysis is used to forecast future values for the indicator,
independent of other variables. Unlike trends in security analysis, trends for most economic indicators occur over
years or even decades. For instance, significant changes in productivity growth or the unemployment rate can take
years to emerge.

CYCLICAL TRENDS VERSUS SECULAR TRENDS

Economists and investors must distinguish between cyclical trends and secular trends in key economic variables.
Every cycle contains four basic components: expansion, peak, contraction, and recession. Indicators or sectors that
move in tandem with the economic cycle are called pro cyclical, while those that move in the opposite direction to
the cycle are called countercyclical. Analysts may also refer to these two groups as being correlated or negatively
correlated with the cycle. Variables do not necessarily have to move in lockstep with the economic cycle. For
example, growth in consumer spending, which is pro cyclical, tends to peak before the peak in the economic cycle.
The cycles themselves also form a much longer trend known as a secular trend. A secular trend unfolds over many
years or even decades compared to a traditional economic cycle, which covers three to five years. The following
example will help clarify the distinction.

EXAMPLE
Interest rates tend to rise in the expansionary and peak phases of an economic cycle as inflation pressures build
and central banks move to raise official rates. Interest rates fall during the contraction and recession phases of
the cycle as slower economic growth reduces inflation pressure, creates unemployment, and ultimately causes
the central bank to lower rates.
If during the course of two or more of these cycles, fiscal policy is non-expansionary (meaning that the
government is either reducing its deficit or generating surpluses), then the longer-term trend for interest rates
would likely be downward because improved finances allow the government’s borrowing requirements to fall,
taking pressure off bond yields. This trend was observed during the 1990s even though there were still cyclical
highs and lows in interest rates over the course of this decade.

Currencies also tend to follow secular trends, since their underlying valuations are determined by long-run trends in
relative inflation, trade, and current account balances.
Remember, even when an indicator reinforces a view about the current stage of the cycle for a sector or an
economy, it may also be creating noise and masking the underlying secular trend.

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SOURCES OF INFORMATION
Investment advisors and investors have access to many sources of economic and market intelligence and should
know where to find the information they need. If an investment dealer has an economics department or advisory
group, this is the best place to start. Advisors should become familiar with the various publications produced by
their economics department and determine the relevance to their clients.
Most of the information that economists use in their own analysis comes from sources that are also available to
the public, including government statistical organizations, the Internet, or electronic platforms such as Bloomberg
or Reuters. Professionals also follow newscasts during trading sessions to stay up to date on events and economic
releases.

A TYPICAL SESSION
To understand more about the process of economic analysis and how it relates to making investment decisions, the
following reviews a typical trading day and discusses how an economist provides support for investment advisors
and other investors during the session.
Usually the day starts with either a conference call or meeting at which the economist provides a summary of the
events that occurred during overnight and overseas trading, an analysis of how these events may affect domestic
(or regional) markets, and a preview of the events scheduled for that day. Since economic calendars that note the
date and approximate time that economic data will be released are widely available, investment advisors expect
more from these meetings than just what economic releases are coming and when. They need an assessment of
risks relating to the consensus expectations for a release or event.
During the trading session, economists, market strategists, and equity analysts provide timely and market-focused
analysis of unfolding events, followed by more in-depth analysis later in the day. Investment advisors and clients
usually have questions following the initial analysis of the data, so toward the end of the session, economists
compile a summary of the day’s events. Special focus meetings and conference calls may be held when the firm’s
outlook has been materially changed by the day’s events.

WHAT ARE ECONOMIC FORECASTS?

One of the key products that come out of an economics department is a set of economic forecasts. An economic
forecast is simply an economist’s or economics department’s prediction for the outcome of a particular economic
indicator or event, including the release of economic data, the contents of an important policymaker’s speech, or
the results of a planned central bank decision on interest rates.
Economic forecasts are used both inside and outside the investment industry. Corporate budgets and government
fiscal outlooks all start with a set of assumptions about the macroeconomic situation. Even if an economics
department does not have a direct business relationship with companies or governments, that department’s view
on the economy and interest rates can still contribute to the general outlook. Companies develop hiring plans
or capital expenditure plans based on the forecast. Governments alter spending and taxation according to the
economic outlook. Central banks, even though they tend to set monetary policy in an independent framework, also
reconcile their outlook with the forecasts of private-sector economists.
Investment advisors need to understand the rationale behind the forecast, how it is put together, and how it
compares to other estimates.
Forecasts for many variables are created using a bottom-up or add-up model. What this means is that underlying
economic components are estimated or projected based on available information and the expected relationship
between this information and the variable being estimated. Then the components are aggregated (or added up) to
produce a sector or macro forecast.

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The easiest illustration of a bottom-up model is the one used to forecast expenditure-based Gross Domestic
Product (GDP), which is a measure of the total output of an economy based on spending. GDP is simply the sum of
four variables, as shown in Figure 5.1.
An easy way to build a bottom-up model of expenditure-based GDP is to use a spreadsheet program. The model
contains the variables for a given time period; the variables are used to forecast future values of GDP by using
projections for each of the components and then adding them up.

Figure 5.1 | Components of GDP Calculation

GDP = C + I + G + X − M

Consumption Private Government Exports minus

(C) Investment (I) Spending (G) Imports (X-M)

Gross Domestic Product is calculated by adding consumption, private investment, government spending, and exports minus imports.

Economic theory usually forms the basis for the relationships between variables in a particular model, such as the
effect of higher interest rates on a forecast of automobile purchases. Since such purchases are normally financed
through a personal loan or a lease, the level of interest rates determines the cost of financing and therefore the
effective cost of the vehicle. Higher financing charges, without a commensurate increase in household income or a
decrease in the prices of other items in the consumption basket, result in either a drop in demand for or spending on
vehicles or a move away from other purchases to maintain the same level of spending on vehicles.

ECONOMETRIC ANALYSIS
Since an underlying theory may not apply to all situations or countries, economists test it mathematically using
econometric analysis, which is also known as econometrics. In the simplest terms, econometrics is the bridge
between economic theory and applied economics. Real-world observations, mathematics, and statistical analysis
are combined to test a theory and then mathematically represent that theory so that it can be used to predict the
future value of an economic variable.
For example, if the theory in question is that “automobile sales decline when interest rates rise,” econometric
analysis could examine a historical set of sales data against a time series of interest rates to determine whether a
relationship indeed existed and, if so, quantify that relationship in the form of an equation. An economist could then
use this equation in an overall forecast for consumption in the GDP model.
As we saw, a model can be as simple as a spreadsheet that combines data and relationships to arrive at an estimate
for a specific variable. Before the introduction of personal computers, most economists had to rely on large-scale
macroeconomic models stored on mainframe computers at large consulting firms or institutions. When personal
computers became widespread, economics departments could buy models and make their own modifications. The
introduction of spreadsheet software boosted the popularity of bottom-up macroeconomic models, which form the
majority of forecasts today.
One advantage of these models is that economists can incorporate new information into an overall forecast fairly
quickly. For example, the GDP forecast for a particular quarter is largely driven by estimates for consumption since
consumption typically represents 50% to 60% of GDP. The consumption estimate is in turn driven by weekly and
monthly reports on retail sales. As consumption reports arrive, economists can adjust their quarterly consumption
forecasts and hence their GDP forecasts.

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Not all economic forecasts are generated solely by mathematically deduced results for the underlying components.
Some components are themselves forecasts based on available data. These are known as endogenous variables,
meaning they depend on variables that are also generated from the forecast.
Assume that a quantifiable relationship between auto sales and interest rates was found and factored into an overall
forecast for consumption in a GDP model. It is known, however, that interest rates move up and down according to
the strength or weakness of the overall economy (as measured by GDP, which is what is being modeled), so interest
rates will influence auto sales. It is also known that over time the strength in auto sales will in turn affect interest
rates.
In this case, auto sales are considered the endogenous variable within the GDP model. Models that have this
iterative quality – meaning that one variable affects another variable that itself affects the original variable – are
rare among financial sector economics departments, mainly because of the resources that must be spent just
to maintain these models. When building a model of GDP, economists tend to make qualitative assessments of
components like auto sales based on qualitative forecasts for interest rates.
Variables that are not determined from within the model are called exogenous variables. An example in a GDP
model would be government spending. Although a government bases its spending decisions on the state of the
economy, that is only part of the process. Policies will often be implemented deliberately to affect the economy
or to address a policy objective that is unrelated to the economy. The chosen level of spending will be unknown to
the economist until it is published in the budget, so economists must predict what the spending levels will be and
include these predictions in the model. Differences in assumptions about exogenous variables explain much of the
variation between the forecasts of different economists.

CONSENSUS FORECASTS
Investors sometimes base trading decisions on their own economic views and projections and sometimes on
a single external forecast (or on the forecast of their investment dealer’s economics department, if available).
Often, however, they arrive at a decision by considering a wide range of forecasts, or what is called the consensus
forecast, which is simply the average forecast of several economists. The term consensus (which implies agreement)
may seem an odd way to label the average projection from a group of economists that may have widely different
opinions on the outlook for the economy. However, just as consensus estimates for corporate profits determine the
movement in share prices when actual results are released, consensus economic forecasts provide a reference to
which the reported performance of the economy and its sectors are compared. There are two situations in which the
consensus forecast comes into play:
• Providing an average view of the major economic variables used in making investment and business decisions
• Positioning markets ahead of key economic releases

Nearly every day of the month, official statistical agencies report on some measure of economic activity. For the
major releases, several economists are polled about their expectations, often by an electronic wire service (e.g.,
Bloomberg or Reuters). From this survey, the service will calculate a consensus forecast. Sometimes it will also
report the high and low estimates for the survey. The consensus is then disseminated to the investment community
through the wire services or in the print media. Most economics departments offer investment advisors and their
clients a weekly calendar of releases, showing the date and time for the release of a report, the consensus forecast,
and sometimes the department’s estimate.

DEVIATIONS FROM THE CONSENSUS FORECAST

When an economics report is released, market participants compare the outcome to the published consensus and
react. Each market – equities, bonds, money market, commodities, or foreign exchange – may react differently to a
particular report. Some markets will ignore a release even when it causes another market to move in a significant
manner.

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Probably the most closely watched economic indicator is the monthly U.S. payrolls report. If the actual increase in
payrolls in a given month is larger than the consensus forecast, equity prices tend to rally, bond markets tend to sell
off, the U.S. dollar tends to strengthen, and in some situations, commodity prices will increase on the perception
that stronger employment growth suggests stronger overall demand for commodities.
If the difference between the outcome and consensus forecast is large, the movements of the various markets will
tend to be more significant. Some indicators, because of the economic weight they carry, have a greater impact on
market direction for a given deviation from consensus than other indicators. Depending on the current stage of the
economic cycle, markets tend to gravitate away from reliance on one set of indicators to another set. If growth in
the economy has been evident for several months, markets tend to place less emphasis on indicators of real growth
(as opposed to growth from price increases), such as GDP, spending, and employment, and more emphasis on
inflation indicators. The emphasis is on inflation because as growth continues, the central bank would be expected
to tighten monetary policy to dampen inflation, and thus would be monitoring inflation variables.
If an investment advisor has access to consensus estimates, it might seem that figuring out market reaction to a
set of possible outcomes would be fairly simple. Unfortunately, it is not. Since there are often situations in which
interim information arrives after the consensus is calculated (usually several days before the actual event) but
before the actual data release, the market often formulates what is called a whisper estimate. You will not find this
estimate printed anywhere, but people on the trading and sales desks will discuss this estimate in the lead-up to
the report. Rather than comparing the outcome to the printed consensus, they react to deviations from the whisper
estimate instead.
Over the years, those who conduct economic surveys have tried to improve the accuracy and relevance of their
consensus estimates by surveying economists about interim information. Typically there is not enough time to get a
representative sample size before the data release, and so the revised consensus estimates may be no more relevant
than the original ones. This does not mean that the whisper estimate is a superior forecast of the release; it may
turn out that the published consensus was more accurate. It is important to understand, however, that investment
success ultimately comes down to how the market actually perceives reality and not how it should perceive reality.
For long-term investors, the day-to-day deviations and gyrations of the market are inconsequential. For short-term
portfolio decisions, however, investment advisors need to know the complete market intelligence picture behind
each release, from published consensus to whisper estimates. Advisors may learn about the whisper estimates from
the morning meeting and economist briefing notes, but more typically, they get this information in direct discussion
with trading and sales people.
Some economic events are not the subject of published consensus forecasts at all. Most weekly reports, for
example, do not have consensus estimates associated with them (except for the Thursday report on U.S. jobless
claims). Weekly reports include the U.S. reports on mortgage applications, weekly retail sales (the two main reports
come from Instinet Research Redbook and the International Council of Shopping Centers), and the Bloomberg
Consumer Comfort Index. (We review an extensive list of economic indicators in the next section.) These reports
attract attention among investors, however, by providing leading indications for some important monthly economic
reports (employment, retail sales, and consumer confidence).
In addition to the weekly reports, investors also have to take into account the less-frequent releases of government
non-data reports, such as the Federal Reserve’s Beige Book, the Bank of Canada’s Monetary Policy Report, and
speeches by government and central bank officials, not to mention decisions and announcements by international
bodies such as the G8 and OPEC (Organization of the Petroleum Exporting Countries). None of these carry
numerical estimates, but the market nonetheless has expectations about their potential impact on security prices.

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WHAT ARE KEY ECONOMIC METRICS?

To be an effective metric or variable in terms of indicating the direction of a security or market, it is not sufficient
simply to display good correlation with the security or market – the variable must have a predictive quality.
Consider the monthly Thomson Reuters/University of Michigan Consumer Sentiment Index. This is a closely
watched indicator that can produce gyrations in consumer-sector stocks or the debt securities market because
participants interpret changes up or down as suggestions of strength or weakness in consumer spending. The
sentiment index is not, however, always predictive. The sentiment index may move sharply simply in reaction to
changes in the equity market. If U.S. stock indexes rally 5% in a given month, individuals tend to feel more positive
about their finances, but that does not say much about how they will spend their money in the next six months. In
contrast, the more comprehensive Conference Board Consumer Confidence Index, which is also a monthly report,
sheds light not only on the general sentiment of consumers, but also on their responses to employment, incomes,
and general business conditions, as well as their purchasing intentions for automobiles, homes, and household
appliances. In other words, trends in these components can tell us something about what consumers are apt to do
over the coming months, because their actions are not just a knee-jerk reaction to positive or negative returns from
one month’s stock market performance.
The choice of which metrics to follow also depends on the particular market. Those who follow equity securities are
interested in things that affect the direction of the top lines (revenue) and bottom lines (profitability) of companies
and sectors. They are interested in variables that measure overall economic performance and expenditures, such as
GDP, consumption, manufacturing sentiment, housing, and employment, as well as indicators that shed light on
costs, such as producer prices, import prices, wages, and the employment cost index.
Those who follow the bond market are more interested in the direction of interest rates. They need information on
general economic growth, since the pace of economic growth relative to what is called the potential rate of growth
is important in terms of assessing what the central bank is likely to do with interest rates. The potential rate of
growth is the rate at which the economy should grow when all resources (labour and capital) are fully utilized. The
Bank of Canada currently estimates Canada’s potential growth rate at 2.5% annually. When an economy grows at
a rate below its potential growth rate, excess capacity and ultimately disinflation (a decline in the inflation rate)
are created, which normally prompts a central bank to lower rates. On the other hand, if growth exceeds potential,
implying excess demand, the result is likely to be higher inflation and a tightening in monetary policy by the central
bank. Therefore, direct indicators of inflation, like the Consumer Price Index, are important in determining the
direction of central bank policy and interest rates.
Even more important are those indicators that a central bank has publicly identified as leading indicators of
inflation, since monetary policy is usually formulated to anticipate changes in the inflation rate that are not in
reaction to current changes in inflation. Fiscal policy metrics (level of government spending and taxation) can affect
equity market performance, but the strongest correlations are found with the bond market because the size of a
government fiscal deficit or surplus has direct implications for the size of government bond issues. The larger the
supply of bonds, all other things being equal, the greater the downward impact on bond prices, which in turn implies
rising interest rates overall and possibly a change in the shape of the yield curve.
From 1998 to 2008, the Canadian federal government ran a fiscal surplus, and from 1998 to 2001, the U.S. federal
government also ran a fiscal surplus. Fiscal surpluses reduce the borrowing needs of governments, so the supply of
U.S. Treasury notes and bonds was lower in these years relative to what it had been in the past. At the same time,
the U.S. government stopped issuing 30-year bonds altogether. This reduction in expected future supply caused
prices of U.S. 30-year bonds to rise relative to shorter-maturity bonds, which meant that 30-year yields fell more
than the rest of the yield curve. Traditionally, this situation occurs only when a central bank is aggressively raising
rates to stem inflation pressures, which forces shorter-term yields to spike higher at a time when the market “prices
out” implied inflation from the longer-dated areas of the curve. That is, in anticipation of lower inflation, the market
will bid up the prices (and thereby drive down the yields) of long-term bonds, which would have been depressed
because of higher inflation expectations.

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It is beyond the scope of this book to discuss how this effect influences not only the bond market but also parts
of the equity market (for example, interest rate–sensitive shares such as those of utilities and banks), but it is
important to understand how certain metrics have market implications outside the pure analysis of the economy.
Tables 5.1 and 5.2 show economic indicators for Canada and the United States. The Canadian indicators are
compiled and released by Statistics Canada, except for housing starts, which are compiled and released by Canada
Mortgage and Housing Corporation (CMHC). Some of the data are seasonally adjusted to remove or minimize the
effect of seasonality and get a better comparison of year-to-year trends.

Table 5.1 | Canadian Indicators

Indicator Description Timeliness

National Income and Expenditure Details income and expenditures in economy Quarterly
Accounts (GDP)

Real GDP by Industry Measures value added by labour and capital on Monthly
an industry-by-industry basis

Labour Force Survey Survey of working-age population Monthly

Canadian International Merchandise Details total merchandise exports and imports Monthly
Trade Balance

Industrial Capacity Utilization Rate Measures extent of productive capacity usage Quarterly

Monthly Survey of Manufacturing Estimates of manufacturers’ shipments, inventories, Monthly

and orders

Retail Trade Survey Survey of retail sales by region Monthly

Housing Starts Measures number of new, self-contained Monthly

housing units started

Consumer Price Index Indicator of rate of price changes for goods and Monthly
services at the consumer level

Industrial Product Price Index Measures prices that producers earn as goods leave Monthly
their plants

Source: Statistics Canada, Canada Mortgage and Housing Corporation

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Table 5.2 | U.S. Indicators

Indicator Description Timeliness

Gross Domestic Product Output of goods and services produced by labour Estimated Quarterly,
and property Revised Monthly

Unemployment Report Household survey on labour conditions Monthly

ISM Manufacturing Index Measures activity of manufacturing sector Monthly

Philadelphia Fed Survey Survey of activity of manufacturing firms in Monthly

Philadelphia Federal Reserve District

Retail Sales Estimate of sales and inventories at retail Monthly

and food stores

Housing Starts Number of new, privately owned housing units started Monthly

Consumer Price Index Changes in prices paid by urban consumers for a Monthly
market basket of goods and services

Producer Price Index Changes in selling prices received by domestic Monthly

producers of goods and services

Federal Reserve Beige Book Summary of economic conditions in Federal Eight times
Reserve districts a year

Conference Board Consumer Survey of nationwide consumer confidence Monthly

Confidence Index

Source: U.S. Bureau of Economic Analysis, Institute of Supply Management, Philadelphia Federal Reserve Bank, U.S. Census Bureau, U.S.
Bureau of Labor Statistics, U.S. Federal Reserve, U.S. Conference Board

INTERNATIONAL ECONOMIC DEVELOPMENTS AND EVENTS

Elements of risk from outside the domestic economy affect forecasts and often make them less relevant. A terrorist
attack is an extreme example of an uncertain and unpredictable event that can affect many sectors of the economy
and the financial markets, not just in the country where it occurred, but around the world as well.
Some would argue that a discussion of event risk does not belong in a chapter on economic analysis; however,
reports of actual economic data interrelate with their forecast levels to determine market direction, and the
observation of these events defines cyclical and secular trends. How structural shifts in the economy affect the
direction of indicators has not been discussed.
The emergence of global terrorism has had a structural impact on economic sectors, governments, and central bank
policy formation, and in some cases has led to a breakdown in the traditional correlations between economic factors
and security prices. The best economic models in the world will still fail to predict terrorist acts, but economic
analysis can reveal how terrorism affects the behaviour of businesses and households.
Similarly, the examination of changing patterns of the global economy can help investment professionals determine
the direction of the domestic economy. In the 1970s, economists did not forecast the OPEC oil crisis, but the impact
on crude oil and gasoline prices created a massive shift in the consumption profile for automobiles (from larger
vehicles to smaller, fuel-efficient ones), an increase in energy conservation measures (including expanded nuclear
generation), and ultimately a reduction of dependence on OPEC supply, with several non-OPEC nations increasing
their oil production.

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Country risk is slightly more predictable, as in the case of the Asian financial crisis of 1997 and the Russian debt
default of 1998. However, as the collapse of Long Term Capital Management (LTCM), a hedge fund located in
Greenwich, Connecticut shows, models can still fail. Russia’s default led investors to buy default-free assets such
as U.S. government bonds, which caused U.S. bond yields to fall precipitously. LTCM had built a bond portfolio that
was long Russian bonds and short U.S. government bonds (which resulted in LTCM losing billions of dollars).
Finally, global economic developments affect the North American economy and therefore market direction.
Economists, investment advisors, and investors need to stay abreast of these developments, since even though they
usually take place over a very long term, domestic economic effects still catch the market by surprise. One case
in point is the growing dominance of China on the world economic stage. After more than 30 years of strong GDP
growth, China is now in the top three of global economic superpowers. Over time, its demand for raw materials
sent commodity prices soaring (such as those of base metals and crude oil). Even companies that had no business
interaction with China found that their cost base had increased because of higher input costs, which directly
affected their profitability, capital expenditures, and hiring decisions. In the typical bottom-up fashion, we saw the
overall impact on the macro economy.
China’s ascension as a global economic power created large trade imbalances with the United States, and these
imbalances affected the movement of global exchange rates, even in countries that have minimal economic
relations with China. For example, although China is Canada’s second-largest trading partner, in terms of the
products imported into Canada, Canada’s share of China’s import bill is barely 1%. Yet, the downward effect that
China’s trade imbalance with the United States had on the U.S. dollar caused the Canadian dollar to appreciate
relative to the U.S. dollar, which reduced the competitiveness and profitability of Canadian firms exporting to the
U.S. market.
So profound has been China’s effect on the major industrialized countries of the world that economists are already
starting to look at the next potential candidates for economic supergrowth, including India.

WHAT IS INDUSTRY ANALYSIS?

OVERVIEW
Industry or sector1 analysis is the broadest level of research performed by equity analysts. At this level, analysts
identify, gather, and analyze information relevant to particular industries. Among other things, this includes:
• The industry’s position within various classification schemes and the implications of this position for expected
industry performance.
• Characteristics such as past sales and earnings performance, competitive conditions, relationship with the
government, and labour conditions.

Analysts publish their analyses and forecasts in specialized industry reports and, to a lesser extent, individual
company reports.

THE IMPORTANCE OF INDUSTRY ANALYSIS

Within a framework of equity analysis, industry analysis is important for the following reasons:
• During any time period, the returns on alternative industries or sectors vary within a wide range. This makes
industry analysis important for targeting an industry for investment.

1
In most cases, the terms industry and sector are interchangeable. Sometimes, however, “sector” is used in a broader sense, in that a sector
may be made up of one or more industries.

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• The rate of return for individual industries varies over time, so historical performance is not necessarily a good
predictor of future performance. This makes the analysis of future performance – that is, industry analysis –
important.
• It is easier to find a good stock within an industry that is expected to do well than it is to find a good stock
within one that is not.

USERS OF INDUSTRY ANALYSIS

Investment strategists Use industry analysis in combination with their view of the economy and markets in
general to recommend sector allocations for equity portfolios. The recommended
allocations are usually related to the industry or sector’s weight within a market index,
such as the S&P/TSX Composite Index in Canada or the S&P 500 Index in the United
States. For example, an investment strategist might recommend investors overweight
technology stocks or underweight the utility sector. The overweight call means that
investors should allocate a greater percentage of their equity portfolio to technology
stocks than the weighting of technology stocks within the market index. That is, if
technology stocks make up 20% of the index, then the recommendation is to invest
more than 20% of an equity portfolio in technology stocks.

Equity portfolio Use industry analysis to help determine sector allocations for their equity portfolios.
managers The importance of industry analysis to a particular portfolio manager depends on the
manager’s investing strategy or style. Those that favour a top-down approach rely on
industry data more than those that use a bottom-up value style. Bottom-up managers
are usually interested in what analysts have to say about the various industries, but they
may not use this information directly in their stock selection process.

Investment advisors Use industry analysis in a variety of ways and to varying degrees. Advisors that have
adopted a top-down approach to investing or that have active and sophisticated clients
who want to apply a strict top-down approach to stock selection need to be aware of the
industry analysis to which they have access, and need to take a view on the outlook for
various industries. Advisors that have either adopted another approach to stock selection
or that do not have active clients who want to invest using a top-down approach have
less need for industry analysis, but usually follow it to augment their knowledge of the
stocks that they recommend to their clients.

INDUSTRY CLASSIFICATION
CLASSIFICATION BY PRODUCT OR SERVICE
A natural way to classify an industry is by the product or service it produces. For example, companies that sell cars
are in the automobile industry. This type of classification is common and is how investment dealers define the
coverage universe of their equity analysts.
Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI), two well-known providers of equity
indexes, have developed a comprehensive industry and sector classification system known as GICS (Global Industry
Classification System). S&P and MSCI assign every company within their indexes to one of 157 sub-industries. Each
sub-industry belongs to one of 68 industries that are apportioned into 24 industry groups and then into 10 sectors.
Table 5.3 lists the 11 sectors and their 24 associated industry groups. Note that some sectors have only one industry
group.

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Table 5.3 | GICS Sectors and Industry Groups

GICS Sectors GICS Industry Groups

Consumer Discretionary • Automobiles and Components

• Consumer Durables and Apparel
• Consumer Services
• Media
• Retailing

Consumer Staples • Food and Staples Retailing

• Food, Beverage, and Tobacco
• Household and Personal Products

Energy • Energy

Financials • Banks
• Diversified Financials
• Insurance

Health Care • Health Care Equipment and Services

• Pharmaceuticals, Biotechnology, and Life Sciences

Industrials • Capital Goods

• Commercial and Professional Services
• Transportation

Information Technology • Software and Services

• Technology Hardware and Equipment
• Semiconductors and Equipment

Materials • Materials

Telecommunications Services • Telecommunications Services

Utilities • Utilities

Real Estate • Real Estate

Source: Standard & Poor’s

The GICS Industry Groups are similar to how many investment dealers define their analysts’ coverage universes.
For example, Table 5.4 lists the industry coverage as it might look to a Canadian investment dealer.

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Table 5.4 | Industry Coverage at a Canadian Investment Dealer

• Automobiles and Components • Hardware and Equipment

• Banks and Diversified Financials • Health Care and Biotechnology
• Building Products and Machinery • Insurance
• Cable • Media
• Chemicals • Metals and Mining
• Diversified Income Trusts • Oil and Gas
• Food and Beverage • Real Estate and REITS
• Food and Staples Retailing • Software
• Forest Products • Special Situations
• Gas and Electric Utilities • Telecommunications Services
• Gold • Transportation and Aerospace
Most analysts cover a single industry, but some cover two or three. For example, the dealer whose industry coverage
is listed in Table 5.4 has a single analyst covering both Telecommunications Services and Cable. Occasionally, more
than one analyst is assigned to a particular industry.
Most large Canadian dealers have similar industry coverage, while some of the smaller, niche dealers specialize in a
smaller number of industries and sectors.
One problem with classifying an industry by the product or service it sells is that some companies operate in more
than one industry. For example, before being broken up into several entities, it was difficult to compare a company
like CP Limited to any other company because its revenue came from hotels, shipping, and rail. Analyzing the
growth potential of such companies is complex. For companies that operate solely in one industry, analysis provides
insight into their short-term behaviour. For example, Barrick Gold Corporation is easily identified as a gold producer
and thus its classification has relevance.

CLASSIFICATION BY INDUSTRY LIFE CYCLE

Analysts can learn a lot about the companies within their coverage universe if they can place the industry within one
of the following four life cycle stages: pioneer or emerging growth, expansion or rapid growth, stable or mature, and
declining. Each stage is associated with different growth rates and risks. Determining where an industry is in its life
cycle is important in timing investment decisions.

PIONEER OR EMERGING GROWTH

In a pioneering industry with rapid growth expectations, the risk of company failure is high. Demand is usually
growing and may exceed supply, which can lead to quick expansion by companies and outstanding rates of return.
These rates of return may induce other companies to enter the field.
As firms establish themselves in the industry, the weaker ones are forced out of business. The departure of these
firms may be caused by price and market share competition, or by the burden of start-up costs, or even by the
emergence of standards for the industry.
This is potentially the most profitable – but also the riskiest – stage for investors. The fate of many Internet
companies in the late 1990s offers evidence of both profitability and risk. Many companies had little more than a
great concept and no prospect of earnings for many years. Stock prices reflected high earnings growth expectations,
and many companies failed to meet these expectations in the short term. This failure caused their stock prices to
collapse, cutting off any chance of additional financing and eventually causing many to file for bankruptcy.

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The speculative nature of investments in companies at this stage of development makes these securities suitable
only for risk-tolerant investors.

EXPANSION OR RAPID GROWTH

Fewer companies are in the expansion phase of the industry life cycle than are in the pioneering phase, since some
of the pioneers have failed or have been acquired by stronger companies. Companies that survive the pioneering
stage are usually characterized by healthy and continuous growth, although growth rates tend to be lower than
those of the pioneering stage. Earnings forecasts are more realistic than with the pioneers, but unpleasant surprises
in earnings can be disastrous.
As firms grow, they fine-tune their products, take advantage of economies of scale, and become more experienced.
As a result, they can lower their prices. Once an industry has reached this stage, the mortality rate of companies
drops considerably. The combination of greater stability and growth can produce good investment opportunities.
Many initial public offerings (IPOs) have entered this stage of development. They have established their product line
over several years and still have many years of growth ahead.

STABLE OR MATURE
Decline and possible stagnation in the industry represents the transition from expansion to stabilization. The
market may be saturated or consumers may have lost interest in the product. During this transition, the value of a
company’s stock may diminish.
During the stabilization phase, a company usually has a steady earnings stream and forecasts are generally reliable.
The trend of earnings is important. An occasional stumble does not necessarily lead to large price swings in the
company’s stock, but a trend of falling earnings may indicate that the industry is being eroded by technological
innovation.
This may be an excellent time to get out of an industry; however, some companies find innovative ways to survive
by changing to accommodate shifts in demand. This innovation may result in the company repositioning itself at an
earlier stage of the life cycle.

DECLINE
Industries in the declining stage tend to grow at rates equivalent to the overall economy or worse. That makes these
industries generally unattractive candidates for investment.
It is not always easy to know where an industry is in its life cycle. The start of the pioneering stage is easy to identify,
but after that, the stages are harder to pinpoint.

CLASSIFICATION BY REACTION TO THE ECONOMIC CYCLE

Changes in the economy do not affect all industries identically. If a downturn occurs, industries that produce luxury
items may feel the effects more than, say, the agriculture industry. Another way to classify industries is thus by their
reactions to changes in the economic cycle. The four major classifications under this system are growth, cyclical,
defensive, and cyclical-growth.

Growth industries Have a successful rate of growth no matter how the economy is performing. What
constitutes a growth industry may change over time. What one generation considers
a luxury, the next generation may consider a necessity. The home electronics industry
and the computer industry have become staples in modern society and are considered
growth industries today. To follow these industries, analysts need to understand changes
in society and determine how people will spend their money, regardless of economic
conditions.

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Cyclical industries Have growth patterns similar to those of the business cycle. These industries are hurt
in recessions but grow during periods of economic prosperity. The housing industry is a
good example. When times are bad, few people can afford a new house and a mortgage.
When people are more secure, the housing industry picks up. Successfully predicting the
fortunes of these industries depends on the accuracy of economic forecasts.

Defensive industries Do not suffer as greatly as other industries during recessions; however, they tend to
grow below the market rate during an upturn in the economy. These industries are
usually involved in the production of necessities, so their products are always in demand.
Investments in these industries are more secure than those in cyclical industries. The
utilities industry is a defensive industry. Earnings of utilities companies are generally very
predictable, with pricing regulated by government boards.

Cyclical-growth Are a relatively new category. These industries share attributes of both the cyclical and
industries the growth industries because they change and update their products. This process
increases efficiency and boosts profits. The pattern of growth for these industries is more
complex than for the other classifications. Determining exactly when the industry will
face a downturn is much harder than it is for the cyclical industries.

INDUSTRY CHARACTERISTICS
The analysis of a particular industry includes looking at its specific characteristics, including past sales and earnings
performance, competitive conditions, its relationship with the government, and labour conditions.

PAST SALES AND EARNINGS PERFORMANCE

Healthy sales and earnings performance over a long period of time suggest stability; however, industries in the
pioneering stage have little history to analyze. By observing the past sales and earnings of an industry, analysts
may notice patterns that can be linked to the economic cycle. For example, if an industry’s past sales and earnings
indicate that it is a cyclical industry, then its sales and earnings will be affected by where the economy is in its cycle
and where it is likely to be over the forecast horizon.
Of course, knowledge of past sales and earnings patterns does not guarantee that the future will be a continuation
of the past. Changes in consumer tastes, changes in technology, or other changes may cause industries to falter
regardless of the state of the economy.

COMPETITION
Equity analysts also study competitive conditions, and one of the most important factors is barriers to entry. How
free are new firms to enter the industry? As the number of firms in an industry becomes smaller, the better the
expected rates of return for each firm. Barriers to entry can include product differentiation, absolute advantage, and
economies of scale.
Product differentiation usually means a name brand that reminds consumers about the quality of the product. For
example, an established company such as Coca-Cola has a distinct advantage over any new product that enters the
soft drink industry because people everywhere recognize the Coke name. When consumers must choose between
Coke and an unknown brand at a similar price, they usually choose the familiar Coke.
The existence of an absolute advantage compared to new entrants in the industry helps to deter new firms
from entering the business. The advantage might be lower costs because a company has patented, proprietary
technology. No new company would be able to produce a similar product at a similar price without access to the
same technology.

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Economies of scale give established firms an advantage. When industries have high start-up costs, the marginal
cost of the goods they produce decreases as output rises because the initial cost is spread out over more products.
A new firm that does not possess a significant market share produces fewer products over which it can spread its
costs, so the average cost per unit is higher than that of an established firm. All things being equal, larger firms can
sell their products at prices below those of newer, smaller firms and may thereby force newer firms out of business.
New manufacturing technologies that allow mass customization are eroding the notion of economies of scale in
some industries. They make smaller production runs more economical and have lower start-up costs.
The Internet has helped with many of the communication obstacles that previously made customization complex.
Barriers to entry are not what they used to be, but they are signs that an industry is protected against new
competition and may make the industry a good potential investment. Government-imposed barriers, such as trade
barriers, may also protect the industry; however, these barriers are subject to the political will of the government
and may change when the government changes.

RESPONSE TO DEMOGRAPHIC AND LIFESTYLE CHANGES

Demographics include the study of population shifts and changes in the age distribution and income distribution
of the population. These factors may indicate the growth prospects of a particular industry. The most anticipated
and well-analyzed demographic trend has been the aging of the baby boomers. Most analysts anticipate that as
the baby boomers enter their retirement years, they will spend more on health care, financial services, and leisure
and travel.
Lifestyle changes can have a similar impact. The tricky part of analyzing lifestyle changes is to determine whether
they are a permanent or at least long-term change, or are just another passing fad that will be forgotten in a
few years.

RESPONSE TO TECHNOLOGICAL CHANGE

Analysts must be alert to potential substitutes of the industry’s product made possible by technological innovation.
When technological innovations occur, the analyst must determine whether the industry’s product can withstand
the loss of market share brought on by new products.
For example, the distribution sector of the economy was radically altered by computers and just-in-time ordering.
The impact of just-in-time inventory replenishment made it possible for companies to deal directly with factories.
Manufacturers that could not establish the necessary computer connections lost their position as suppliers.

RELATIONSHIP WITH GOVERNMENT

The importance of this relationship cannot be understated. If the government considers an industry important, then
it may protect it if it begins to falter. If the government does not approve of the industry, for example, because it
causes environmental or health problems then it can enact legislation that reduces the industry’s profitability.
Also, during trade negotiations, the government must choose which industries to open up to foreign competition
and how much to open them up. If one industry is not as important to the government as another, the less
important industry may face increased competition that could cut into profits and lower share prices. Under NAFTA,
certain industries are more exposed to risk from foreign competitors than others. For example, Canadian banks are
protected because of limits on foreign ownership. Smaller employers, most notably in manufacturing industries,
have been much more exposed to NAFTA competition. Of course, the best manufacturers have taken advantage of
opportunities south of the border.

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LABOUR CONDITIONS
The degree to which labour conditions of an industry affect its profitability is affected by four factors:

Degree of automation If labour is an important production factor, strikes can affect profits. Also, changes in the
wages earned by the industry’s workers affect the bottom line. If labour is less important
and wages rise quickly, the industry can change to a partially or completely automated
system. If such changes are possible, the industry will be largely insulated from worker
demands for higher wages. Increasingly, manufacturers are installing computerized
machinery that increases production with the same or fewer workers. As these
manufacturers rely less on labour, their sensitivity to wage demands decreases. This fact
has been used as an argument for the return of manufacturing to high-wage countries
like Canada from low-labour-cost countries like Mexico. In an industry where labour has
already been reduced by automation, like the soft-drink bottling industry, labour cost
sensitivity is far less important than the cost of sugar or foreign exchange rates.

Management and If almost every contract negotiation provokes a strike, the company’s stock price may be
labour relations affected near the end of each contract period. The anticipation of a strike will cause stock
prices to fall in proportion to how much damage the strike is likely to do to the company.

Level of share Companies that have share ownership or profitability-based bonus compensation
ownership schemes may have not only fewer strikes but also higher productivity.

Labour productivity By raising the average productivity of the workers, companies can offset higher costs
caused by increases in wages.

USING INDUSTRY ANALYSIS

In the top-down approach, investment advisors can use industry analysis to under-, market-, or overweight each
industry in a portfolio. If the expected return of a particular industry is higher than the rate accepted by the
consensus, investment advisors can add a risk-adjusted value to a portfolio by overweighting that industry. If,
however, the portfolio becomes less diversified, the level of risk may increase. Also, there are added trade and
management costs involved in acting on industry analysis.
Sector rotation involves adjusting the portfolio weights of different economic sectors or industry categories in
anticipation of stock market trends. For example, if an investment advisor expects a long growth period in the
present economic cycle, she might overweight a portfolio in companies that produce capital goods, which tend to
perform well during such periods. Alternatively, the investment advisor might underweight a portfolio in financial
companies if she thinks that interest rates will rise in the near future2. Sector rotation can also mean adjusting
portfolio weights in stocks according to particular attributes such as size, dividend policy, or value measures.

2
The Canadian Securities Course mentioned “As interest rates rise, banks must raise the rate they pay on deposits to attract funds. At the
same time, a large part of their revenue is derived from mortgages with fixed interest rates. The result is a profit squeeze when interest rates
rise.”

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Although most industries move in the same direction at the same time, the amount of movement is often quite
different for different industries. The key to industry timing is to identify the leaders at each stage of the market
cycle. Investment advisors can select industry groups on the basis of factors such as type of business, degree of
economic sensitivity, and exposure to international markets. When considering sector rotation strategies, it is
important to keep several principles in mind:
• Prices for companies in industries with similar economic sensitivity tend to move together (that is, they display
positive return correlations). This reduces the potential benefits of rotation gains. In the early stages of an
economic recovery, forest products and mineral industries both experience increased demand for their products.
A portfolio manager probably needs exposure to only one of these to benefit from a change in the economy.
Holding securities in both industries could leave the portfolio overexposed to cyclical stocks.
• It is important to focus on industry activity, not size.
• Diversification across and within industries is not a straightforward task in Canada. One or two companies tend
to dominate most sectors. Notable exceptions include the banks and the oil and gas producers.

The success of a sector rotation strategy depends on forecasting overall market activity, as well as activity within
industry categories. Although the potential benefits from this approach are significant, it is difficult to predict which
sectors will excel. Many sector rotators pay particular attention to industry momentum, trying to spot changes in
leadership among the various industries. Momentum rankings list industries according to their performance over
the past several periods. These rankings indicate the consistency of an industry’s performance relative to others and
to the broad market, and can provide insight into relative performance in the near future.

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SUMMARY
By the end of this chapter, you will be able to:
1. Describe how economics drives the development of investment strategies.
• The rationale for many investment decisions ultimately rests on their view of the economy as a whole. This
view consists of a set of assumptions about economic variables or events that affect economic growth,
inflation, and, ultimately, corporate profitability.
• Adjustments are made so the effect of seasonality is either removed or minimized.
• It is important to distinguish between cyclical trends and secular trends in key economic variables.
2. Describe how economic forecasts are created.
• An economic forecast is simply an economist’s or economics department’s prediction for the outcome of a
particular economic indicator or event.
• Forecasts for many variables are created using a bottom-up or add-up model. What this means is that
underlying economic components are estimated or projected based on available information and the
expected relationship between this information and the variable being estimated. Then the components are
aggregated (or added up) to produce a sector or macro forecast.
• Econometrics is the bridge between economic theory and applied economics. Real-world observations,
mathematics, and statistical analysis are combined to test a theory and then mathematically represent that
theory so that it can be used to predict the future value of an economic variable.

3. List key economic metrics.

• Canadian economic indicators: national income and expenditure accounts (GDP), real GDP by industry, labour
force survey, Canadian international merchandise trade balance, industrial capacity utilization rate, monthly
survey of manufacturing, retail trade survey, housing starts, consumer price index, and industrial product price
index.
• U.S. economic indicators: gross domestic product, unemployment report, ISM manufacturing index,
Philadelphia fed survey, retail sales, housing starts, consumer price index, producer price index, federal reserve
beige book, conference board consumer confidence index.

4. Explain how international economic events affect an economic forecast.

• The emergence of global terrorism has had a structural impact on economic sectors, governments, and
central bank policy formation, and in some cases has led to a breakdown in the traditional correlations
between economic factors and security prices.
• Global economic developments affect the North American economy and therefore market direction.
5. Explain how industry analysis is used.
• Investment strategists use industry analysis in combination with their view of the economy and markets in
general to recommend sector allocations for equity portfolios.
• Equity portfolio managers use industry analysis to help determine sector allocations for their equity
portfolios.
• Investment advisors use industry analysis in a variety of ways and to varying degrees.

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6. Describe the ways industries are classified.

• Classification by product or service: A natural way to classify an industry is by the product or service it
produces. Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI), two well known
providers of equity indexes, have developed a comprehensive industry and sector classification system known
as GICS (Global Industry Classification System).
• Classification by industry life cycle: pioneer or emerging growth, expansion or rapid growth, stable or mature,
decline.
• Classification by reaction to the economic cycle: growth, cyclical, defensive and cyclical-growth.
7. Identify the ways industry characteristics affect profitability.
• The analysis of a particular industry includes looking at its specific characteristics, including past sales and
earnings performance, competition, response to demographic and lifestyle changes, response to technological
change, its relationship with the government, and labour conditions.

8. Apply economic and industry analysis.

• In the top-down approach, investment advisors can use industry analysis to under-, market-, or overweight
each industry in a portfolio.
• Sector rotation involves adjusting the portfolio weights of different economic sectors or industry categories
in anticipation of stock market trends. Many sector rotators pay particular attention to industry momentum,
trying to spot changes in leadership among the various industries.

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 Analysis of Equity Securities II:
Company Analysis and 6
Valuation

CONTENT AREAS

What Is the Difference Between IFRS and GAAP?

What Is Company Analysis?

What Models Can Be Used to Value Stocks?

How Are Resource Companies Analyzed?

What Are the Limits of Accounting Data?

LEARNING OBJECTIVES

1 | Explain the difference between IFRS and GAAP.

2 | Identify various sources of company information.

3 | Assess the quality of a company based on its earnings.

4 | List the merits of different absolute valuation models.

5 | Assess the advantages and disadvantages of different valuation techniques.

6 | Calculate a firm’s worth using any of the valuation models.

7 | Explain the metrics used in the analysis of oil and gas companies.

8 | Calculate the metrics used in the analysis of oil and gas companies.

9 | Explain the metrics used in the analysis of mining companies.

10 | Explain the limitations of financial statement analysis.

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INTRODUCTION
This chapter on company analysis and valuation introduces the process that securities analysts go through to
produce a full research report or a short investment recommendation. A securities analyst’s role can be seen as
being similar to an investigator. Good securities analysts are curious and a little skeptical. After examining the facts,
they must form an opinion and make recommendations that investment advisors and investors will rely on to buy
and sell securities.

WHAT IS THE DIFFERENCE BETWEEN IFRS AND GAAP?

Generally Accepted Accounting Principles (GAAP) had been the standard for over 75 years in the United States and
Canada, guiding the preparation and presentation of financial information for a publicly traded company.
Canadian publicly accountable enterprises (‘PAEs’) gave up using GAAP and switched to International Financial
Reporting Standards (IFRS) for annual reporting periods starting on or after January 1, 2011.
The major ‘philosophical’ difference between the two accounting methodologies is that IFRS is almost entirely
principle-based whereas U.S. GAAP is primarily rules-based. Rules-based accounting is more rigid, meaning specific
procedures are observed when preparing financial statements. This makes for less ambiguity but also increases the
complexity of the process. There is also more difficulty in making rules that fit every situation.
In principle-based accounting, guidelines are more general because the goal is to have the completed financial
statements achieve a set of good reporting objectives. An example of a good reporting objective is sufficient
disclosure of data so that an investor can make an objective analysis. A principles-based process can be adapted
to many more situations than a rules-based process. Also by having a wide adoption of principle-based standards,
comparison of financial statements among firms across industries or across countries will be easier to do.
Under IFRS, both accounting professionals and company management are required to use the accounting policy
that best reflects the economic aspect of the company’s transactions. Accordingly, there is a greater likelihood
that similar companies might account for the same transaction in a (somewhat) different manner. But IFRS does
require, as an offset, a more extensive and detailed disclosure by the company to explain why particular accounting
treatments are utilized.

WHAT IS COMPANY ANALYSIS?

OVERVIEW
Company analysis involves understanding the company’s business, analyzing the company’s financial statements,
and forecasting the company’s future financial performance. Equity analysts communicate the results of company
analysis and valuation in research reports that can be as short as a single page or as long as several dozen pages.
Shorter, more frequently released research reports are often called comments, notes, or flashes. Analysts produce
these in response to new information about the company, such as an announcement made by the company or a
rumour in the market, or to update investors during a quiet period. In addition to describing the new information,
the note usually summarizes the analyst’s current view on the stock and indicates how the analyst feels the
company will be affected by the news. Depending on the potential significance of the news, and the impact it has
on the analyst’s opinion of the company and its stock, the short report may be followed up with a more detailed
report explaining how the news affects the analyst’s opinion and rating.
Longer research reports are released less frequently than shorter notes. When an analyst initiates coverage of
a company, they generally write a longer report to detail the company’s operations, provide an overview of the

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industry in which the company operates, discuss the competitive landscape the company faces, and provide detailed
financial models and a valuation. Once the company is under coverage, longer reports usually contain updated
analysis and valuation information and can be released independently of any news on the company. Industry reports
are also generally longer reports. They provide more detailed information about operations in the industry and the
competitive landscape, and make comparative analyses of the primary companies and their relative investment
value.

SOURCES AND ANALYSIS OF COMPANY INFORMATION

Equity analysts learn about the companies they cover by reading and analyzing financial statements and other
regulatory filings; talking to and assessing the quality of companies’ senior management through site visits,
conference calls, and investor tradeshows; and other sources of information.

FINANCIAL STATEMENTS
Financial statements are prepared by company management. There are four major parts of a company’s financial
statements:
• The statement of financial position (formerly called the balance sheet) lists a company’s assets, equity, and
liabilities at a specified point in time.
• The statement of comprehensive income shows the company’s revenue and expenses over a specified period
of time.
• The statement of changes in equity provides a link between the statement of comprehensive income and the
statement of financial position at a specified point in time.
• The statement of cash flows outlines the cash inflow and outflow for the company over a specified period
of time.

STATEMENT OF FINANCIAL POSITION

The statement of financial position has three main sections: assets, equity and liabilities. Assets are owned by
the company (e.g., cash) or owed to the company (e.g., accounts receivable). Equity is the total capital invested
in shares of the company plus the company’s accumulated profit and loss over time. Liabilities are owed by the
company (e.g., long-term debt).
Assets, equity, and liabilities are related to each other as follows:
Assets = Equity + Liabilities (6.1)

or, equivalently:
Assets – Liabilities = Equity

Equity analysts use statements of financial position to, among other things, calculate liquidity and risk analysis
ratios (which are discussed later in this chapter). In addition, by combining information from the statement
of financial position and statement of comprehensive income, analysts can calculate measures such as return
on equity.

STATEMENT OF COMPREHENSIVE INCOME

The statement of comprehensive income lists all revenue and expenses for a specified time period. Revenue is
funds that have been received or that will be received for the delivery of goods or services to customers. Expenses
are amounts that have been paid or assets that have been used up during the time period in which the delivery of
goods and/or services took place. The difference between revenue and expenses is known as profit.

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 CHAPTER 6 | ANALYSIS OF EQUITY SECURITIES II: COMPANY ANALYSIS AND VALUATION 6 •5

STATEMENT OF CASH FLOWS

A statement of comprehensive income matches expenses with revenue to determine the profit of a company.
Although profit is an important indicator of a company’s performance and sustainability, its survival over the long
term ultimately depends on its ability to generate cash. Since a statement of comprehensive income does not
include a breakdown of cash inflow and outflow and includes some non-cash accounting items, companies are
required to prepare a statement of cash flows. The statement of cash flows breaks down a company’s sources and
uses of cash in a particular period according to its operating activities, investing activities, and financing activities.
• Cash flow from operating activities equals cash received from the sale of goods or services minus cash used to
generate the revenue.
• Cash flow from investing activities equals cash received from the sale of long-term assets minus cash used to
buy long-term assets plus any dividends received from associates.
• Cash flow from financing activities equals cash received from the sale of new shares or the issuance of new debt
securities minus cash paid to buy back shares, repay debt securities, or pay dividends.

The sum of the cash flows from the three activities equals the change in the company’s cash (as reported on the
statement of financial position) from one period to the next.

Figure 6.1 | Components of the Statement of Cash Flows

Cash flow from Cash received from the sale Cash used to generate
= –
operating activities of goods or services the sales
+
Cash flow from Cash received from the sale Cash used to buy Any dividend received
= – +
investing activities of long-term assets long-term assets from associates
+
Cash paid to buy
Cash received from the sale
Cash flow from back shares, repay
= of new shares or the issuance –
financing activities debt securities, or pay
of new debt securities
dividends
=
Change in company This figure shows the relationship between the various
cash flow components of a company’s flow of cash and assets.

NOTES TO FINANCIAL STATEMENTS

When a company publishes its annual report to shareholders, it includes a set of notes to financial statements.
The notes explain the company’s accounting policies and provide more detailed information about individual items
in the company’s financial statements. The notes to financial statements vary in length from company to company.
By putting most of the details in the notes rather than in the financial statements themselves, the company is
able to present a “cleaner” set of financial statements in that the financial statement appears on one page free of
explanatory information.
Examples of specific items in the general financial statements are reviewed below to illustrate what an equity
analyst can find out by examining the financial statements only. Then examples of some information from the notes
are discussed to show how they might provide further insights about company activity.

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EXAMPLE #1
Revenue
In a consolidated statement of comprehensive income, a firm would state its revenue. An analyst might divide
the current figure by the prior period figure to arrive at a growth rate. For example, in 2017, if revenue was
$4.94 billion and in 2016 it was $3.34 billion, the analyst might conclude that revenue increased 48% year over
year. This seems like impressive performance; however, the notes may indicate that the firm made significant
acquisitions that added to revenue in 2017.

EXAMPLE #2
Long-Term Debt
On the statement of financial position, long-term debt is listed under non-current liabilities. To gain an
understanding of the composition of the coupon rate(s) and maturity date(s) associated with the long-term debt,
an analyst would turn to the notes where this information is detailed.

MANAGEMENT’S DISCUSSION AND ANALYSIS

In Canada, a company’s interim and annual financial statements contain a section titled Management’s
Discussion and Analysis (MD&A). The MD&A gives “the reader the ability to look at the issuer through the eyes
of management.” This is an important section of the annual report, as suggested by the standard line in the MD&A,
“The Management’s Discussion and Analysis should be read in conjunction with the Company’s consolidated
financial statements and notes.” This section provides insight into the company that is not provided in the financial
statements or notes. The MD&A should be written in plain language so that current and potential investors are able
to understand it.
Along with management’s analysis of the company’s financial results, the MD&A should comment on the company’s
future prospects and explain risks that may affect whether the company attains the desired result in the future.
The following examples will illustrate the uses of the MD&A excerpts as a source of supplementary information.

MD&A EXCERPT #1
Revenue for the year ended December 31, 2017 rose 7.6% to $47.9 million from $44.5 million in the prior year,
primarily as a result of increased revenue from all of the Company’s product lines.
Commentary: The MD&A explains that the increase in revenue occurred through all products. If, for instance,
the increase in revenue had occurred in a few select products only, then analysts would need to examine the
significance of those products. An across-the-board increase in revenue reduces the reliance on one product and
bodes well for the company.

MD&A EXCERPT #2
Gross profit margin for the 2017 fiscal year improved to 40.4% of revenue compared with 38.3% of revenue in
fiscal 2016. The majority of the improvement in gross profit margin in 2017 was due to increased revenue from
the Company’s high-margin products.
Commentary: Analysts can use the financial statements to calculate the two gross profit margin figures
mentioned in the MD&A. The financial statements do not show, however, why the ratio increased from 2016
to 2017. The MD&A explains that the increase in gross profit margin was due mostly to increased revenue from
high-margin products. Analysts might conclude from this that revenue from these products are driving growth in
the company’s overall revenue, and that forecasts for the company will depend on forecasts for revenue growth in
these product lines.

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OTHER REGULATORY FILINGS

To maintain a listing on a Canadian stock exchange, a company must file audited annual financial statements
through the System for Electronic Document Analysis and Retrieval (SEDAR). These audited annual financial
statements must be prepared according to IFRS and be approved by the company’s board of directors. If a company
has securities listed on the Toronto Stock Exchange (TSX), it must file these audited annual financial statements
within 90 days of the end of its financial year-end. If a company has securities listed only on the TSX Venture
Exchange or CSE, it must file the statements within 120 days of the end of its fiscal year.
Listed companies must also file interim unaudited financial statements. For companies with securities listed on the
TSX, the statements must be filed through SEDAR within 45 days of the end of the interim period. If securities are
listed only on the TSX Venture Exchange or CSE, the filing period is within 60 days of the end of the interim period.
In both cases, comparative figures from the previous fiscal year for the applicable time periods are also required.
In the United States, most companies must file a Form 10-K with the Securities and Exchange Commission (SEC)
within 90 days of the end of the company’s fiscal year. This annual report provides a comprehensive overview of
the company’s business. Most reporting companies in the United States also file a Form 10-Q quarterly (every
three months). This form includes unaudited financial statements and provides a continuing view of the company’s
financial position during the year. The report must be filed for each of the first three fiscal quarters of the company’s
fiscal year and is due within 45 days of the close of the quarter.

OTHER SOURCES OF INFORMATION

Conference calls with analysts and investors can be an additional source of information about individual companies.
These calls allow analysts to ask management questions on a wide variety of topics affecting the company.
Unlike the annual general meeting, which is usually held in the city in which the company has its headquarters, a
conference call gives investors from around the country the opportunity to hear management speak and to become
more familiar with those in charge.
After the release of interim financial statements, companies often hold conference calls to provide additional
clarification and to answer questions about the information released. Some calls are open only to analysts; others
are open to analysts and investors.
In addition, analysts are usually given the opportunity to meet with a company’s senior management from time
to time. Analysts do not use these meetings to probe for inside information but to ask questions and to clarify
information previously provided, without the disruptions of a conference call setting during which other analysts or
investors are asking questions. Analysts also speak with a company’s suppliers and customers to gain further insight
into the company’s operations.

QUALITATIVE COMPANY ANALYSIS

Qualitative analysis of a firm’s business considers how the firm generates revenue and profit. A firm’s success
competing within its industry depends on its sustained competitive advantage. The degree of sustained competitive
advantage and the duration for which it is maintained depend on three factors:

Low costs Among its competitors, the firm should have one of the lowest if not the lowest cost
structure in the industry.

Differentiation The firm’s products and services should stand out and be unique in the minds of its
customers.

Focus The firm serves a narrow customer base that is underserved or overlooked by
the industry.

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To determine whether a firm has a sustained competitive advantage, the analyst should consider four areas
of a company’s operations: corporate issues, products and markets, production and distribution, and level of
competition.
1. Corporate issues include matters of company strategy, management, personnel, properties, and the
government laws that regulate company performance. There should be a credible business plan that will
drive revenue in the long term. Management must be able to match corporate resources with competitors.
Growth, either internally generated or obtained through acquisitions, should be manageable. Corporate culture
should be conducive to productivity and retention of good employees. Management should have a depth of
experience and operate as a team.
2. Products and markets refer to the sale and development of the firm’s goods and services, and the markets
they operate in. The firm should have a variety of products that are well differentiated from its competitors.
Corporate growth depends on a steady stream of product extensions and innovations. The research and
development budgets should be well funded. The company should have a diverse customer base to lessen
dependency on a single purchaser. The marketing strategy should be sufficient to sustain and grow revenue.
Customer service must be able to meet the needs of clients in all matters in a timely fashion.
3. Production and distribution are related to manufacturing and delivery of the firm’s end products. The company
should understand and be able to avoid bottlenecks in the production process and there should be sufficient
production facilities. Production should depend on a number of suppliers to lessen delivery risk, and inputs
could be a business issue if their value is volatile and a large component of manufacturing. The firm should
possess a secure distribution channel or acquire one once revenue reaches a threshold level.
4. Level of competition determines the degree of profitability. The higher the barriers to entry, the fewer
competitors there will be and the more profitable the industry will be for the established companies.

FINANCIAL STATEMENT ANALYSIS

Analysts do more than just read a company’s financial statements and notes; they analyze and scrutinize them to
better understand factors that affected the company’s past financial performance. Historical financial performance,
when combined with other information about the company and its industry, forms the basis for a set of projected
financial statements.
Analysts perform financial statement analysis using spreadsheet models of the company’s historical and projected
financial results. These models are often complex, mapping data and relationships among several worksheets and
files. At the same time, they are usually designed to be flexible so that they can be updated quickly when new
information arrives.
Analysts are particularly interested in identifying and analyzing key drivers of the company’s performance. Most
financial statement items are derived from the key drivers, which makes them very important for building projected
financial statements. Key drivers include, among other things, revenue, cost of sales, depreciation, and capital
expenditures.

RATIO ANALYSIS
A significant part of financial statement analysis involves ratio analysis. It is important for investment advisors
to be at least familiar with the terminology because it is frequently used in analyst research reports. Financial
statement ratios, which compare the relative value of two or more financial statement values, are usually broken
down into the following categories based on what they tell analysts about the company’s performance:
• Liquidity ratios measure a company’s ability to meet its short-term obligations. Common measures of liquidity
include the current ratio and the quick ratio. The current ratio is current assets divided by current liabilities.
The quick ratio is current assets minus inventories, then divided by current liabilities.

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• Risk analysis ratios are used to determine how well the company deals with its debt obligations, including its
ability to service required debt payments (coverage) and to assume more debt (capacity). Interest coverage
and asset coverage are two common measures of debt coverage. The debt-to-equity ratio is a common
measure of debt capacity.
• Operating performance ratios help determine a firm’s long-run growth and survival prospects. Profitability
measures how well the company has made use of its resources. Common measures include gross profit
margin, net profit margin, and return on common equity (ROE).
• Value ratios gauge the market’s perception of the value of a company’s shares relative to its dividends,
earnings, or other measures such as the equity value (or book value) per common share. Common value ratios
include price-to-earnings (P/E) and dividend yield. When valuing a company and making recommendations,
analysts often justify their decisions on a value ratio being above or below some benchmark value. The section
on valuation later in this chapter discusses these ratios further.

Table 6.1 summarizes key financial ratios that analysts use to forecast company performance and, ultimately,
to make an investment recommendation.

Table 6.1 | Summary of Financial Ratios – for information only

Ratio Name Ratio Use

LIQUIDITY RATIOS

Working capital (or current) ratio Indicates a company’s ability to meet its short-term debt.

Quick (or acid test) ratio A more stringent test than the current ratio, the quick ratio excludes inventory
from the calculation.

RISK ANALYSIS RATIOS

Asset coverage Allows the debt holder to measure the protection provided by the company’s
tangible assets* after all liabilities have been met.
* Tangible assets are the company’s assets other than goodwill and other intangible assets.

Debt to equity ratio Identifies the amount of debt incurred by a company in relation to the equity
for the company.

Cash flow to total debt Used to analyze the company’s ability to repay funds it has borrowed.

Interest coverage Reveals the company’s ability to pay the interest charges on its debt.

OPERATING PERFORMANCE RATIOS

Gross profit margin Measures the company’s rate of profit after allowing for the cost of sales.

Net profit margin Measures the company’s rate of profit after allowing for all expenses and taxes.

Net return on common equity Measures the return generated to common shareholders.

Inventory turnover common Measures the amount of times per period that the company’s inventory is
theoretically bought and sold.

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Table 6.1 | Summary of Financial Ratios – for information only

Ratio Name Ratio Use

VALUE RATIOS

Percentage of available earnings Measures the amount of common share dividends paid out by the company
paid out as common dividends as a percentage of the company’s profit.

Earnings per common share Shows the earnings available to each common share.

Dividend yield Shows the annual dividend as a percentage of the current market price of
the company’s shares.

Price-to-earnings multiple Shows how many times earnings investors are currently paying for the
common stock.

Equity value per common share Represents the value of the company’s equity theoretically available for each
common share of the company.

Some or all of these ratios ultimately help analysts forecast key drivers of performance when they create projected
financial statements.

PROJECTING FUTURE FINANCIAL STATEMENTS

The final step in financial statement analysis is creating a set of projected financial statements. These projections
play a crucial role in company valuation because, in conjunction with one or more valuation models, they
determine the analyst’s recommendation for the company’s shares.
Analysts usually create projections for quarterly and annual statements several years into the future, although the
further out they go, the less reliable the estimates become. Generally speaking, projected statements are meant
to present the results of an analyst’s view of the future. If the projected statements turn out to be wrong, which
is likely given the dynamic and uncertain nature of doing business, the analyst’s recommendation may also turn
out to be wrong. The extent of the discrepancies between actual results and projections, and the reasons for those
discrepancies, will affect the impact on the value of the shares in the market. A single analyst’s projections that
are out of line with actual results may have little or no effect on the market for the company’s shares. If, however,
actual results are significantly discrepant from consensus estimates, the effect is likely to be more drastic.

ANALYSIS OF EARNINGS
Of all the forecasts made by an equity analyst, none is given more attention than the earnings forecast. Four times
a year investors face earnings season, which coincides with the large number of companies reporting earnings in
the weeks following the end of March, June, September, and December.
The markets have little mercy for companies that fail to live up to the analysts’ consensus forecast, in some cases
punishing the stock price severely. Depending on the degree of deviation from the forecast, up or down, analysts
may change their ratings, their earnings and other projections.

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EARNINGS PER SHARE

At the most basic level, earnings per share (EPS) is calculated as:
Profit (6.2)
EPS 
Weighted-average number of common shares outstanding

When companies release their financial statements, they calculate two versions of their EPS: basic and fully diluted.
Analysts also calculate two EPS for a company based on their adjusted statements for the company. The versions
use different methods for determining the number of common shares outstanding:

Basic earnings per share Is calculated only on the weighted-average number of common shares outstanding.

Fully diluted earnings Includes the weighted-average number of common shares outstanding, all stock
per share options granted by the company, all unexpired warrants, and all shares that could
be issued from the conversion of other securities, such as convertible debentures
and convertible preferred shares. In summary, the fully diluted number of shares is a
hypothetical number that reflects the number of common shares outstanding if the
weighted-average of the current common shares and all granted and unexpired claims
for potential common shares were added together.

If the company has granted stock options, issued warrants, or has convertible securities, the higher number of
common shares in the fully diluted figure increases the denominator in the formula relative to that used in the basic
EPS. For example, if a company has only unexpired stock options, the fully diluted EPS would be lower than the
basic EPS. If the company does not have any of these potentially “extra” common shares, then basic EPS and fully
diluted EPS will be the same number.
In determining the number of shares issued and outstanding for a company, the weighted-average number of shares
is used to factor in the length of time the shares have been issued and outstanding during the fiscal time period. If
no shares were issued during the fiscal time period, then the beginning number of shares will be the same as the
ending number of shares. However, if shares were issued during the fiscal period, the length of time those shares
were outstanding is taken into account. The following example illustrates the calculation of the weighted-average
number of shares outstanding for a particular fiscal time period.

EXAMPLE
On January 1, Year 1, Company × had 1,000,000 common shares issued and outstanding. On May 1, Year 1,
Company × completed a bought deal that resulted in 300,000 shares being issued. What was the weighted-
average number of shares outstanding on December 31, Year 1 for Company X?
The number of shares outstanding on December 31, Year 1 is 1,300,000 (1,000,000 plus 300,000 issued during
the year).
The weighted-average number of shares outstanding is:
1,000,000 × 4/12 = 333,333
+ 1,300,000 × 8/12 = 866,667
1,200,000
The calculation involves multiplying the number of shares by the fraction of the time the shares were
outstanding. There are four months from January 1 to April 30; therefore, 1,000,000 shares were outstanding
for 4/12 of the year. There are eight months from May 1 to December 31; therefore 1,300,000 shares were
outstanding for the other 8/12 of the year.

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RETURN ON EQUITY
Return on equity (ROE) is more precisely defined as the return on common equity. The common shareholders
are the owners of the company. Once the company’s other securities holders (such as debt securities) have been
paid from profit, the residual income or loss is added to or subtracted from the retained earnings section of the
statement of financial position. The retained earnings shown on the statement of financial position represent the
cumulative profit or loss that accrues to the common shareholders.
ROE is commonly shown as an overall number. Analysts will break down the ROE number into components and
comment on each one. Some analysts use a three-part breakdown, others a five-part breakdown. In both cases, the
purpose is to determine where the growth (or decline) in ROE came from. Comparisons with previous time periods
also help the analyst determine trends in ROE.
Equation 6.3 shows the three-part ROE breakdown commonly used by analysts. This model is commonly known as
the DuPont model.

Profit Revenue Total Assets (6.3)

ROE  q q
Revenue Total Assets Common Equity

 Net Profit Margin q Total Asset Turnover q Financial Leverage

Net profit margin Measures the company’s rate of profit after allowing for all expenses and taxes. Analysts
look for a trend toward a large positive number for net profit margin; a trend toward a
smaller net profit margin is negative for the company. Further analysis would be required
to determine why a smaller number occurred. The MD&A section may provide an
explanation.

Total asset turnover Measures the dollar amount of revenue generated per amount of assets. An analyst
looks for a trend over time of an increasing number of revenue relative to total assets.

Financial leverage Measures the total assets divided by the common equity of the company. In most
applications, financial leverage is defined as the ratio of total assets to the average of the
beginning-and end-of-year common equity, rather than just total assets divided by the
beginning or end-of-year figure.

When examining a company’s financial leverage, it is helpful to recall the basic statement of financial position
equation:
Assets = Equity + Liabilities

A higher ROE due to higher financial leverage means the company has more debt (and therefore potentially more
risk). A company with a low level of debt is more likely a candidate to increase its debt level than one with a higher
level of debt. Most medium-sized or large companies have some debt on the statement of financial position;
however, too much debt is a problem because it raises the possibility of default risk. To determine if excessive debt
exists, an analyst can review the company’s capital structure and compare it to industry and historical norms. The
following table shows the breakdown of a hypothetical company’s ROE from 2014 to 2017.

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Year Net Profit Margin (%) Total Asset Turnover Financial Leverage ROE (%)
2014 3.84 1.37 2.47 13.0
2015 2.84 1.39 2.68 10.6
2016 3.28 1.23 2.85 11.5
2017 3.42 1.22 2.85 11.9

The firm’s net profit margin, after declining in 2015, increased over the next two years. This is positive for the
company because it means that the rate of profit is increasing. The revenue generated from the company’s assets
declined in 2016 and 2017. This means the company is generating less revenue in relation to the assets on hand.
The company’s use of debt in its capital structure has increased over the past four years. After a decrease in ROE
in 2015, an increase in financial leverage has contributed to an increasing ROE over the past two years.

Analysts would review the above information along with other ratios and company information to learn if the
increase in financial leverage might cause the debt-to-equity ratio to exceed industry standards. The analyst would
also search the MD&A section of the annual report for management’s explanation, if any, for why the net margin
is increasing.

ROE AND THE SUSTAINABLE GROWTH RATE

The sustainable growth rate of earnings (and dividends for dividend-paying companies) represents the estimated
rate of growth of earnings and dividends that can be sustained for a given level of ROE based on the following two
assumptions:
• The capital structure of the company is constant over time.
• No additional common stock is issued.

The relationship involves a third variable, the earnings retention rate, which is the opposite of the dividend payout
ratio. The portion of earnings paid out as dividends is subtracted from the total earnings to obtain the percentage of
earnings that is retained. In decimal form, the earnings retention, b, rate is equal to (1 – the dividend payout ratio).
Equation 6.4 shows the formula for the estimated sustainable growth rate.
g = b × ROE (6.4)

Where:
g = the estimated sustainable growth rate of earnings and dividends

b = the earnings retention rate

If b is a high number, then the company is keeping available a high percentage of earnings to fund its future growth.
Alternatively, if b is a low number, then a small percentage of earnings is being kept to fund future growth.
The higher the ROE, all else being equal, the higher the sustainable growth rate. Analysts determine the estimated
sustainable growth rate using past growth rates implied from the company financial statements, along with
projections of future ROE and retention rates. The section on valuation later in the chapter will show why the
calculation of the estimated growth rate is important and how it is used to value stocks.

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Here is an example of how an analyst calculates the estimated sustainable growth rate for a hypothetical company.

EXAMPLE
Year Retention Rate Return on Equity (%) Sustainable Growth Rate (%)
2015 0.539 30.5 16.44
2016 0.607 53.8 32.66
2017 0.413 35.0 14.46

In 2015, the company’s profit was $15.1 million and it paid $6.96 million in dividends. This resulted in a retention
ratio of 0.539 (that is, 53.9% of net income was not paid out in the form of dividends and was therefore added
to retained earnings). Analysts use this information in forming an opinion about a future estimated sustainable
growth rate.

ROE AND LEVERAGE

When individuals are unable to pay their bills, they may be forced to declare bankruptcy, which implies that one
is unable to pay one’s debts. Many people buy goods and services with borrowed funds using mortgages, credit
cards, car loans, or lines of credit. A common example of leverage to most people is the purchase of a house. Most
people make an initial payment that is less than 100% of the house’s purchase price. If someone buys a house for
$200,000 using a down payment of $20,000 (10% of the purchase price) and sells it for $230,000 one year later,
that person has benefited from leverage and gained $30,000 on an initial investment of $20,000 (excluding fees).
This is a pre-fee return of 150%. If, however, the same person sells the house for $170,000, then they have lost
$30,000. Given an initial investment of $20,000, this represents a 150% loss.
A company needs to raise capital to finance expansion plans, buy additional equipment, or purchase other
companies. Companies can raise capital by issuing common or preferred shares. Companies can also borrow funds
to use in business operations. A company borrowing funds is essentially using leverage – that is, using another
entity’s money for a specified time period in the hope of earning a return on those funds that is higher than the cost
of those funds.
Leverage can benefit a company. If a company uses the borrowed funds to increase its return to shareholders
(hence increase its ROE), this is a benefit to the shareholders. As we have seen, ROE is one of the components
used in determining the future growth rate for a company. As with individuals that cannot pay their debts, too
much leverage can harm a company. The risk that a company is carrying too much debt is why analysts examine a
company’s capital structure along with the financial leverage component of ROE.
If ROE helps determine a company’s growth rate, and growth is a characteristic of a profitable company, why would
a company not be 100% levered? The answer is that with this much financial leverage, the likelihood of not being
able to make an interest payment increases. In addition, the company’s focus would be on making the next interest
payment, and thus management might forgo opportunities that would enhance its growth but that would require
cash outflow with the strong possibility of no immediate cash inflow.

WHAT MODELS CAN BE USED TO VALUE STOCKS?

OVERVIEW
The focus of this section is on the models and processes equity analysts use to estimate the value of stocks. This
value then forms the basis for the analyst’s recommendation for the stock.
For those investors that believe that all information about a stock is reflected in its current market price, valuation
is not a concern. These types of investors, known as passive investors, do not use words such as undervalued or

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overvalued. Those investors that believe a stock’s current market price might differ from its actual value will seek
out those who use various techniques to determine the actual value for the stock.
A stock’s actual or “true” value is often referred to as its intrinsic value. The intrinsic value of a security represents
the analyst’s opinion or estimate of what the security’s market price should be, either today or at some point in the
future. Ideally, this opinion is based on a complete understanding of the security’s investment characteristics.
At the most basic level, investors will buy a security whose current market price is less than its intrinsic value.
Conversely, investors will sell a security whose current market price is greater than its intrinsic value. If only it were
this simple. Finding the current market price of a stock is simple. Determining the intrinsic value of the stock is
subject to debate, includes assumptions, relies on models, and does not produce the same result from all those who
perform the analysis.
Some equity securities are easier to value than others and certain techniques are particularly appropriate for certain
kinds of securities. This is why it is important to understand an analyst’s rationale for using a particular valuation
technique as well as the characteristics of the security being analyzed.
Any valuation process, no matter how rigidly structured or quantitatively rigorous, requires good judgement.
Because it is necessary to make assumptions about the future performance of a company and its stock, it is often
useful to estimate target price ranges. Forecasts should be continually updated as new information becomes
available. Since much information about the value of a company’s equity is determined during the valuation
process, the process is often as important as the final outcome.
Many different models are used to determine the intrinsic value of a company’s stock. Analysts generally use several
of these for any one company, although, based on past experience and professional judgement, they may have a
preference for or put more weight on the results of one or two of them. In any case, it is always useful to see the
results of different models as a check against the reasonableness of the assumptions of other models.
All valuation models fall into one of two categories:

Absolute valuation Determine a point estimate or precise value for the intrinsic value of a stock based on
models a set of forecast company fundamentals. If the market value of the stock is less than
the model’s intrinsic value, the stock is undervalued; if the market value is greater than
the model’s intrinsic value, the stock is overvalued. In the securities industry, the two
most widely used absolute valuation models are the dividend discount model and
discounted cash flow model.

Relative valuation Determine intrinsic value by comparing one or more of the stock’s value ratios or price
models multiples (such as price-to-earnings, price-to-book value, or price-to-sales ratios) to a
benchmark value for the price multiple. If the stock’s current price multiple is less than
the benchmark value, the stock is undervalued; if it is greater than the benchmark, the
stock is overvalued.

Benchmark values can be derived from the price multiples of other stocks in the company’s sector or industry, the
price multiple of the broad equity market, or the stock’s historical price multiple. Benchmark values can also be
derived from a set of company fundamentals, in which case they can be equated to a dividend discount or cash flow
model.

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ABSOLUTE VALUATION MODELS

DIVIDEND DISCOUNT MODELS
Dividend discount models assume that a stock’s intrinsic value is equal to the present value of a stream of future
dividends. Inputs to dividend discount models include dividend forecasts and/or dividend growth rates, and
discount rates.
• Dividend forecasts and dividend growth rates are usually based on the analyst’s earnings forecasts, which in turn
are derived from projected financial statements.
• Discount rates represent the analyst’s estimate of the market’s required or expected return on the stock. The
required return is usually expressed as a risk-free rate based on government bond yields plus a risk premium,
which is usually based on an asset pricing model such as the capital asset pricing model (CAPM).

Dividend discount models are most suitable for valuing mature companies that pay dividends and have a dividend
policy that bears an understandable and consistent relationship to its profitability.1 Dividend discount models
generally are not used to value companies that do not pay dividends. Equation 6.5 shows the general form of the
dividend discount model.
d
Dt (6.5)
V0  œ1
t 1 r
t

Where:
V0 = the intrinsic value of the stock today
Dt = the dividend paid in time t
r = the discount rate
Clearly, the general form is impossible to implement because it requires forecasting an indefinite number of future
dividends. Therefore, simplified versions of the general form are often used instead.

CONSTANT (GORDON) GROWTH MODEL

One way to simply the dividend forecast is to assume that dividends will grow at a constant rate forever. For
example, if a stock is paying a $1 dividend this year and the estimated dividend growth rate is 5%, next year it will
pay a dividend of $1.05, the year after it will pay $1.1025, and so on. The version of the dividend discount model that
uses this assumption is known as the constant or Gordon growth model. Equation 6.6 shows the formula.
d t
D0 q 1 g (6.6)
V0  œ
t 1 1 r
t

Where:
g = the estimated dividend growth
This hardly looks like an improvement over Equation 6.5 until you realize that with a bit of algebra, Equation 6.6 can
be simplified to Equation 6.7.
D0 q 1 g D1 (6.7)
V0  
rg rg

1
Stowe, John D., Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey, Analysis of Equity Investments: Valuation, (AIMR,
Charlottesville), 2002.

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 CHAPTER 6 | ANALYSIS OF EQUITY SECURITIES II: COMPANY ANALYSIS AND VALUATION 6 • 17

For example, XYZ is trading at $70 a share and will pay a $1.50 dividend this year. An analyst estimates that XYZ’s
dividend will grow at 4% a year forever and that the required return on the stock is 6%. Using this information, the
analyst calculates the intrinsic value of XYZ as $78 per share.
$1.50 q 1.04
V0 
0.06  0.04
$1.56

0.02
 $78

Based on the Gordon growth model, the shares of XYZ are undervalued by $8 since the current price is $70.
Equation 6.7 can be used only when the required return is greater than the estimated dividend growth rate. If the
required return is equal to or less than the estimated dividend growth rate, then the Gordon model cannot be used.
If the discount rate were equal to the estimated dividend growth rate, then the denominator would be 0, resulting
in an infinite intrinsic value, which does not make sense. If the discount rate were less than the estimated dividend
growth rate, then the denominator would be negative, resulting in a negative intrinsic value, which also does not
make sense.
Each version is highly sensitive to the value of the inputs. Small variations in the inputs can cause wide variations in
the estimate of the stock’s intrinsic value. Therefore, although dividend discount models are used as one valuation
tool, they should not be used as the only tool in determining a stock’s intrinsic value.

USING THE GORDON GROWTH MODEL TO ESTIMATE THE EXPECTED RETURN ON A STOCK
Given the current market price of the stock and the estimated growth rate in dividends, analysts and investors often
use the Gordon growth model to estimate the expected return on the stock. Of course, doing so assumes that the
current price of the stock is a true estimate of the stock’s intrinsic value.
To estimate the expected return, Equation 6.7 is rearranged and solved for r, as in Equation 6.8.
D1 (6.8)
r  g
P0

Where:
P0 = the current market price of the stock

Equation 6.8 shows that, based on the Gordon growth model, the expected return on a stock is equal to the stock’s
dividend yield plus its expected growth rate in dividends.
For example, ABC stock is currently trading at $25 a share and will pay a dividend of $1 next year. If an investor
believes the stock is fairly valued and that its dividend will grow at 5% forever, then the expected return on the
stock is 9%.
$1
r  0.05
$25
 0.04 0.05

 0.09  9%

MULTI-STAGE DIVIDEND DISCOUNT MODELS

Not all companies grow their dividends at a constant rate forever. As companies move through their life cycle, their
dividend growth rates can and do change. The general model can easily be adapted to accommodate two, three, or
any number of different stages of growth. Normally, growth rates are assumed to start out high and then decline

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over time. The last stage in a multi-stage dividend discount model usually assumes a constant dividend growth rate
thereafter.

SPECIFIC DIVIDEND FORECASTS

Rather than assume any growth rate stages at all, analysts sometimes use dividend forecasts based on their
financial statement projections. Since these projections do not extend into the future forever, analysts must also
come up with an estimate for the intrinsic value of the stock on the last forecast dividend date. This estimate, which
is often called the stock’s terminal value, can be based on the Gordon growth model or on some other valuation
model. Equation 6.9 shows the formula.
D1 D2 DT VT (6.9)
V0  2
y T
1 r 1 r 1 r
Where:
VT = the terminal value
T = the end of the holding period

For example, an analyst has forecast that ABC will pay dividends of $1.50 next year, $2.50 the following year, $3 the
year after that, and $3.50 the year after that. From there on, the analyst expects the company’s dividend to increase
4% a year forever. The analyst estimates the required return on the stock is 8%.
The first thing the analyst must do is calculate the terminal value of the stock using the Gordon growth model.
Based on a constant growth rate of 4% and a required return of 8%, the terminal value of the stock is $91.
$3.50 q 1.04
V4 
0.08  0.04
$3.64

0.04
 $91

The analyst plugs this value, along with his dividend forecasts, into Equation 6.9 to arrive at an intrinsic value of
$75.37.
$1.50 $2.50 $3 $3.50 $91
V0  2 3 4
1.08 1.08 1.08 1.08

 $1.39 $2.14 $2.38 $69.46

 $75.37

DISCOUNTED CASH FLOW MODELS

Discounted cash flow models assume that a stock’s intrinsic value is equal to the present value of a stream of future
cash flow. Similar to dividend discount models, inputs to discounted cash flow models include cash flow forecasts
and/or cash flow growth rates, and discount rates.
The term cash flow has many applications in the securities industry. Discounted cash flow models use one of two
particular applications of the term known as free cash flow to equity (FCFE) and free cash flow to the firm
(FCFF). This course talks briefly about discounted cash flow models based on FCFE.
Free cash flow to equity is cash flow available to the company’s common shareholders after paying all operating
expenses and interest and principal on its debt after investing in working capital and fixed assets. When we say free
cash flow is available to the company’s common shareholders, we mean that this is the amount that the company
could potentially use to pay dividends.

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Free cash flow to equity is not the same as the cash flow from operations item on the company’s cash flow
statement, although sometimes it is mistaken as such. One big difference between the two is that free cash flow
recognizes that the company must invest in working capital and fixed assets to at least maintain the business.
Free cash flow to the firm is cash flow available to the company’s common shareholders and debt holders. FCFF
includes FCFE plus the after-tax interest expense minus net new borrowing.
This course does not present any discounted cash flow models because they use almost identical formulas to the
ones provided in the section on dividend discount models. There are some differences however, particularly in the
use of FCFF models:
• The discount rate used in FCFF models is the weighted average cost of capital, which is a weighted average of
the required return on the company’s debt and equity securities.
• FCFF models provide an intrinsic value for the entire company, not just its equity. To determine the intrinsic
value of the company’s equity, analysts subtract the market value of the company’s debt securities.

COMPARING DISCOUNTED CASH FLOW TO DIVIDEND DISCOUNT MODELS

It is common for the FCFE model to value equity higher than the dividend discount model. This premium reflects the
value of controlling the firm’s dividend policy. In the infrequent event that the dividend discount model values the
equity higher than the FCFE, dividend payouts exceed free cash flow. This is unsustainable and a negative for equity
values because the firm probably has to borrow funds for the payout. FCFE is more appropriate in valuing a firm
that is likely to be taken over or to have its management changed. The dividend discount model is appropriate when
changes in corporate control are more difficult to effect because of size or legal restrictions on takeovers.
Using FCFF in the cash flow model provides a value for the entire firm, as opposed to FCFE, which values only the
equity; however, the value of the equity can be extracted from the value of the firm by subtracting the market
value of the outstanding debt. The advantage in using the FCFF approach is that it includes after-tax interest cost.
Therefore, FCFF is the appropriate version to use when valuing firms with high leverage or firms in the process of
changing leverage. FCFF is also more appropriate when FCFE is negative, since FCFF considers cash flow before debt
payments and is thus much less likely to be negative.

RELATIVE VALUATION MODELS

PRICE-TO-EARNINGS MULTIPLE
Probably the most common approach to estimating share prices is to use an estimate of the firm’s earnings per
share (EPS) and to multiply that by an appropriate P/E multiple. It is an attractive method because it relates the
price to current earnings, it is simple to compute, and P/E ratios for most common stocks are readily available. P/E
multiples are also believed to be proxies for a number of other firm characteristics that may be of interest, such as
growth opportunities and risk characteristics.
Generally, the historical or trailing P/E ratio is determined as follows:
Market price per common share P0 (6.10)
P E 
EPS of the last four quarters EPS0

The trailing P/E ratio should be adjusted to reflect any changes expected in risk or growth opportunities for the firm.
To see how this is done, we relate the P/E multiple to the same fundamentals used in the Gordon growth dividend
discount model. Denoting the dividend-payout ratio as (1 – b), the expected year-end dividend is:
D1  EPS0 q 1  b q 1 g

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and the intrinsic value is:

EPS0 q 1  b q 1 g
V0 
rg
Dividing both sides by EPS0, we get:

V0 P 1 b q 1 g (6.11)
 
EPS0 E rg

Thus, the P/E ratio increases with increases in the growth rate of dividends (and earnings) and/or decreases in the
discount rate. Decreases in the discount rate occur as the general level of interest rates fall or as risk levels fall.
Despite the intuitive appeal and widespread use of this approach, it has its drawbacks:
• Estimating P/E multiples based on fundamentals works well only for firms that have stable and growing
dividends and a growth rate below the required return on their common shares (r must be greater than g).
• Finding comparable companies and comparing one company with other companies within the same industry
means making subjective judgements about company-specific characteristics such as risk, potential for growth,
and the overall financial health of the company.
• P/E ratios are uninformative when companies have negative (or very small) earnings.
• The volatile nature of earnings implies a great deal of volatility in P/E multiples. For example, the earnings of
cyclical companies fluctuate much more dramatically throughout the business cycle than their stock prices. As a
result, their P/E ratios tend to peak during recessionary periods and trough during the peak of business cycles.

PRICE-TO-BOOK RATIO
Active investors and analysts follow the price-to-book (P/B) ratio closely. Stocks that sell below their book value
are good candidates for value portfolios; stocks that sell at high multiples of their book value are often considered
growth stocks. The book value is determined by dividing the firm’s net book value by the number of common shares
outstanding, then the price-to-book ratio is calculated as follows:
P/B = (P0/BV0) (6.12)

Where:
P0 = market price per common share
BV0 = book value per common share

ADVANTAGES TO USING THE PRICE-TO-BOOK RATIO

There are characteristics of this ratio that make it inherently more useful than other multiples. First, an investor
seeking to buy growth companies at a reasonable price can compare the P/B to the firm’s ROE as a check. Large
discrepancies may be a warning sign. For example, an overvalued stock would have a low ROE and a high P/B. Next,
the book value is a relatively stable measure of value compared to cash flow estimates. Lastly, P/B can be used to
value firms with negative earnings.

DISADVANTAGES TO USING THE PRICE-TO-BOOK RATIO

P/B has limitations that the investor should be aware of. The multiple is only useful when examining capital-
intensive firms or firms with plenty of tangible assets. Book value neglects to include intangible assets like goodwill
and thus is a relatively insignificant number with regard to service firms.

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Book value is not relevant for firms that have a high debt load or sustained losses. Debt can increase liabilities to
the point where they wipe out the value of a company’s tangible assets, creating high P/B values. The high ratio may
hide the value of productive assets.
Any corporate activity that boosts or reduces cash reserves can change book value without materially affecting the
fundamental value of its operations. For example, a share buyback distorts the ratio by reducing the share capital on
the statement of financial position.

THE PRICE-TO-BOOK RATIO AND THE GORDON GROWTH MODEL

Like P/E multiples, P/B multiples can be related to the fundamentals used in the Gordon growth dividend discount
model:
D1 = (EPS0) × (1 – b) × (1 + g)

Since
ROE = (EPS0 / BV0)

then
D1 = (ROE) × (BV0) × (1 – b) × (1 + g)

Substituting this into the numerator of the Gordon growth model yields the following:
ROE q BV0 q 1  b q 1 g
V0 
rg
Dividing both sides by the book value yields:

V0 P ROE q 1  b q 1 g (6.13)
 
BV0 B rg

This equation suggests that P/B is positively related to profitability (as measured by ROE) and expected growth rate,
but negatively related to the discount rate.

PRICE-TO-SALES RATIO
Price-to-sales (P/S) places a monetary value on each dollar of company sales. P/S ratios can be related to the
variables represented in the Gordon growth dividend discount model:
EPS0 q 1  b q 1 g
V0 
rg

Substituting
EPS0 = net profit margin (NI%) × sales per share (Sales0)

into the equation yields:

Sales0 q NI% q 1  b q 1 g
V0 
rg

Dividing both sides by (Sales0) yields:

V0 P NI% q 1  b q 1 g (6.14)
 
Sales0 S rg
Thus the P/S ratio is positively related to profit margins and the growth rate, and negatively related to the
discount rate.

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Sales (or revenue) are never negative. Revenue, unlike earnings or even book value, are available even for the most
troubled or cyclical of firms.
Since revenue is not as volatile as earnings levels, P/S ratios are generally less volatile than P/E multiples. Revenue
figures provide useful information about some corporate decisions, such as the impact of pricing and credit policies,
but not about cost control and profit margins.
Still, the P/S ratio can produce misleading valuations if a firm has trouble controlling costs. Revenue may not
decline even though earnings and book value drop rapidly. For example, a highly leveraged company on the brink of
bankruptcy can have a low P/S ratio.

HOW ARE RESOURCE COMPANIES ANALYZED?

We will look at common methods used to value resources companies. First, we will examine methods used for the
oil and gas industry and then examine methods used for the mining industry.

OIL AND GAS INDUSTRY

RESERVES
Petroleum reserves are an important equity valuation parameter for oil and gas exploration and production
companies. Reserves are estimates of the amount of hydrocarbons owned by the exploration and production
company that are still in the ground. They are important since they represent the majority of the value of the
company since they are the source of all future revenues and cash flows for the firm.
Petroleum reserves are divided into three major classifications. They are defined as follows:

Proved Reserves claimed to have a reasonable certainty of recovery (> 90 percent confidence
interval) under existing technology. Also known as “P90” or “1P” reserves.

Probable Claim of 50 percent recovery confidence interval. Also known as “P50”, “2P” or “proved
+ probable”.

Possible Claim of 10 percent recovery confidence interval. Also known as “P10”, “3P”, or “proved
+ probable + possible”.

The proved category, being of the highest quality due to its very high statistical threshold, forms the basis for a
number of valuation methods. Accordingly, it is divided into a further three sub-classifications as follows:

Proved developed Proved developed reserves that can be recovered through existing wells and facilities,
reserves and by existing methods. Also known as “PDP”. PDP assets are generally not risked (or
discounted by an engineering factor) since they are currently generating cash flow.

Proved developed not Same as PDP but not currently producing. Also known as “PDNP”. PDNP assets are
producing discounted, or risked by about 25 percent.

Proved undeveloped Proved undeveloped reserves are potentially recoverable with existing technology, but
reserves not considered commercially recoverable due to greater than one contingency defined
to include: economic, legal, environmental, political or regulatory risk. Also known as
“PUD”. PUD assets are risked by about 35 percent.

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RESERVE UNITS
The global unit measure of reserves for the oil and gas industry is the BOE. BOE stands for barrel of oil equivalent.
It is defined as follows:
• The barrels (bbls) of oil used when measuring liquid reserves such as oil and natural gas liquids (NGLs), plus
• The amount of natural gas reserves at a conversion ratio of six thousand standard cubic feet (scf) of natural gas
per BOE. This second factor reflects the fact that six thousand scf of natural gas contains the same amount of
heat as one barrel of oil. It is also often referred to as heat or BTU- equivalency. Specifically, one scf of natural
gas contains one BTU and one barrel of oil contains 6 thousand BTU of heat.

The BOE measure is necessary since almost all oil and gas companies have reserves, and production, of oil, NGLs
and natural gas and it is necessary to bring these three types of hydrocarbon assets to one common unit for
analysis.

EXAMPLE
BOE Conversion
Spitfire Oil and Gas Limited is a seven-year old oil and natural gas exploration company headquartered in
Calgary, Alberta. It has been very successful in its exploration and development efforts and had the following 2P
reserves at its prior fiscal year end: 35 million barrels (bbls) of oil and NGLs, and 120 billion scf of natural gas.
(Q) What is the BOE of Spitfire’s entire reserves?
(A) Total BOE = 35 million bbls + (120 billion scf/6 thousand scf per BOE) = 55 million BOE

PRODUCTION RATE
In a manner similar to reserve units, for analysis purposes, daily production rates of liquid hydrocarbons and natural
gas is combined and expressed as BOED or barrels of oil equivalent per day. This brings all forms of hydrocarbon
production to one common unit for analysis.

ECONOMIC VALUE
Economic value (EV) is a standard measure of the economic value of a resource-based company and is calculated
as follows:
EV = Market value of the company’s equity
+ Book value of the debt outstanding
– Amount invested in cash and short term securities (6.15)

EV represents a more complete measure of the combined value of all sources of capital and financing for a company.
This measure incorporates net debt and is a more appropriate, especially for resource-based companies that can
include a significant amount of debt in its capital structure. EV is utilized in numerous valuation metrics.

EXAMPLE
Economic Value
Bearcat Petroleum Limited has 45 million common shares outstanding and is currently trading at $5.50/share.
It has a $200 million line of credit with a major Canadian bank and has currently utilized $100 million of this
credit facility. It also has $45 million of cash and short term investments currently on its statement of financial
position.
(Q) What is Bearcat’s current EV?
(A) EV = (45 million × $5.50/share) + $100 million – $45 million = $302.5 million

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PRODUCTION VALUATION METRIC

The most common production valuation metric for an oil and gas exploration and production company is the
economic value per barrel of oil equivalent produced per day or EV/BOED. It represents the combined debt and
equity market value currently paid per flowing barrel of production (per BOED). It related the market value of the
company per unit of production. Analysts can then compare this metric for similar firms to evaluate the relative
value of the company.
It is important that this metric be considered in the context of the composition of the BOED production figure used
for the company. It is necessary to calculate what portion of the company’s BOED figure is liquids-based versus
natural gas-based since the economics and margins associated with natural gas production can be significantly
different from that associated with liquids-based production. The equity markets are aware of this and will therefore
assign a different market value to the natural gas-based portion of the daily production as compared to the liquids-
based portion.

EXAMPLE
Production Valuation Metric
Canada Oil and Gas Corp has 45 million common shares outstanding and a current market value of $4.25/share.
It has $12.5 million in bank loans outstanding and cash and equivalents of $11.5 million. Its current average daily
production is 4,500 BOED.
(Q) What is Canada Oil and Gas Corp’s economic value per barrel of production equivalent?
(A) EV/BOED = [(45 million × $4.25) + $ 12.5 million – $11.5 million]/4,500 BOED = $42,722/BOED

RESERVE VALUATION METRIC

In a similar manner as the production valuation metric, markets assign a value to the hydrocarbon reserves of an
oil and gas exploration and development company. Economic values can be calculated on the basis of the various
reserve classifications. The most common reserve valuation metric is economic value per 1P or 2P reserves. It
measures the amount the equity market is paying per BOE of reserves.

EXAMPLE
Reserve Valuation Metric
Oaktree Energy Limited has 45 million shares outstanding and is currently trading at $6.50/share. It has $10
million in bank debt and $2.5 million in cash and short term securities on its statement of financial position. It
has 35 million BOE of 1P reserves and 55 million BOE of 2P reserves.
(Q) What is the market valuing Oaktree’s reserves at?
(A-1) EV/1P reserves = [(45 million × $6.50/share) + $10 million – $2.5 million]/35 million BOE
= $8.57/BOE (1P)
(A-2) EV/2P reserves = [(45 million × $6.50/share) + $10 million – $2.5 million]/55 million BOE
= $5.45/BOE (2P)

RESERVE LIFE INDEX

The reserve life index (RLI) represents the number of years it would take to deplete the existing reserves at the
current daily production rate. It is calculated by dividing the company’s current reserves by the current annual
production rate, or as follows:
Current Reserves BOE (6.16)
RLI 
Current Daily Production Rate BOED q 365

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The RLI does not incorporate any potential future reserve growth or changes in production level, and as such
represents the remaining ‘life’ of the company assuming there is no further investment in exploration and
development.
The RLI is utilized in two particular valuation applications. First, it provides a relative valuation metric between
similar-sized competitors. Since oil and gas resources are depleting assets, companies with larger RLI’s offer the
investor a longer-life investment, and all things being equal, should represent better value. Second, an increasing
RLI over time indicates that a company is adding resources at a faster rate than it is increasing production. This
is generally indicative of a successful exploration effort since development activities are considered as low risk,
compared to exploration, and will lead to higher production volumes albeit with a lag due to the time required to
complete wells and tie them into a pipeline for product sale.
RLIs are typically in the range of six to eleven years with top decile exploration companies having RLIs as long as
20 years in some instances.

EXAMPLE
RLI
Quasar Oil and Gas Limited has 2P reserves of 75 million BOE and a current production rate of 15,000 BOED.
(Q1) What is Quasar’s RLI?
(A1) RLI = 75,000,000/(15,000 × 365 days) = 13.7 years

(Q2) How is this number interpreted?

(A2) It means that Quasar could continue to produce at its current daily rate for another 13.7 years even if no
further reserves were discovered.

RECYCLE RATIO
The recycle ratio is a very popular measure of operational profitability and exploration cost efficiency combined. It
relates the current gross profit per barrel of production to the cost of finding and developing an additional barrel of
reserves. In order to calculate it, two separate standard metrics must be calculated, one for the numerator and one
for the denominator of the recycle ratio calculation.
The term gross profit per barrel of production is not normally used in the oil and gas industry but its equivalent
is referred to as a ‘field netback’ and is always calculated and expressed on a per BOED basis. The field netback is
defined and calculated as follows:
Field netback per BOE = Revenue per BOE – direct operating costs per BOE –
provincial royalties per BOE (6.17)

Note that the field netback does not include any administration costs, exploration and development-related costs,
financing costs or any income taxes. It is the standard measure of financial efficiency as related to production
activities alone and, the larger the number the more efficient the production activities are considered to be. Of
course, larger production wells generally lead to more favourable field netbacks.
Meanwhile, the denominator of the recycle ratio calculation represents the costs of adding an additional BOE to the
company’s reserves. It is normally referred to as finding and development costs (F&D) and represents all of the
expenditures directly related to exploration activities and bringing production on line. Of course, lower F&D costs
are indicative of more efficient exploration activities. F&D costs are affected by the type and size of well drilled. The
now more popular horizontally-drilled wells with 20-plus fractures can range in cost from $5 million to $15 million
per well drilled. This compares to exploration costs of approximately $750 thousand to $1 million for conventional
vertical wells. However, the higher exploration costs are considered given the potential for more prolific discoveries
associated with the new drilling technology. Successful horizontal wells can have initial production (IP) rates

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typically in the range of 4 million to 7 million scf/d compared to 1 million scf/d or less for conventional vertically-
drilled natural gas wells.
The recycle ratio can now be calculated as follows:
Field Netback per BOE (6.18)
Recycle Ratio 
F&D Costs per BOE

Note that valuable information is contained in both terms in the recycle ratio calculation and they represent very
useful metrics when analyzing an oil and gas company – especially relative to its peers.

EXAMPLE
Recycle Ratio
For the first quarter of this fiscal year, Spruce Energy Ltd. had the following production and exploration financial
and operational results:
• Average well-head revenue per BOE produced: $87.50/BOE
• Direct oil field operating costs: $18.25/BOE
• Alberta royalty rate: 18% of well-head revenue
• F&D costs: $25 million
• New reserves discovered: 1.25 million BOE

(Q1) What is Spruce’s field netback?

(A1) Field netback = $87.50 per BOE - $18.25 per BOE – ($87.50 × 0.18) = $53.50 per BOE

(Q2) What are Spruce’s F&D costs per BOE of new reserves?
(A2) F&D = $25 million / 1.25 million BOE = $20.00 per BOE

(Q3) What is Spruce’s recycle ratio and explain what it means?

(A3) Recycle ratio = $53.50 / $20.00 = 2.68

This recycle ratio means that Spruce’s field netback per barrel produced during the quarter was sufficient enough
to fund the exploration costs required to add 2.68 BOE of new reserves.

CASH FLOW MULTIPLES

Oil and gas companies are not generally valued on an earnings basis due to the large non-cash components in its
expense structure. However, cash flow multiples are key in the evaluation of these types of companies. The metric
referred to as ‘debt-adjusted cash flow’ (DACF) is utilized for this industry.
DACF is calculated as follows:
DACF = Cash flow from operations + Financing costs (after-tax)
+ Exploration costs (before-tax) +/- Changes in working capital (6.19)

DACF is preferred for analyzing oil and gas companies since:

• It is an after-tax calculation which is good for the oil and gas industry since it often pays high resource and
income taxes, and
• It is independent of a company’s financing decisions

DACF is used in two main valuation metrics for the oil and gas industry: DACF/Share and EV/DACF

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EXAMPLE
DACF
Big Sun Oil and Gas Limited has 30 million common shares outstanding with a market value of $16.50/share.
It has $15 million in bank debt outstanding and $10 million in cash and short-term investments. It had the
following results for the most recent fiscal reporting year:
• Cash flow from operations: $35 million
• Financing costs (after-tax): $12 million
• Exploration costs: $40 million
• Changes in working capital: $5 million (increase)*

(Q1) What is Big Sun’s DACF/Share?

(A1) First calculate its DACF as follows:
DACF = $35 million +$12 million + $40 million – $5 million = $82 million
Second, divide the DACF amount by the number of common shares outstanding:
DACF/Number of Shares outstanding = $82 million / 30 million shares = $2.73/share

(Q2) What is Big Sun’s EV/DACF?

(A2) First, calculate Big Sun’s EV as follows:
EV = (30 million shares × $16.50/share) + $15 million – $10 million = $500 million
Second, divide this amount by the firm’s DACF as follows:
EV/DACF = $500 million / $82 million = 6.1 [This means that the market is willing to pay 6.1 times the
DACF value. This metric is compared to other similar oil and gas companies in order to assess the relative
valuation of Big Sun on a ‘cash flow-type’ of basis.]

* In the DACF formula, we would subtract an increase for changes in working capital. Conversely, we would add a decrease for changes
in working capital.

MINING INDUSTRY
As a resource-based industry, the mining industry, not surprisingly, shares many of the same valuation measure
concepts as the oil and gas industry, albeit with appropriate adjustments where required. One area of difference is
in the definition and calculation of reserves. EV, EV/DACF, DACF/share and EV/reserves for mining companies are
calculated in a similar manner to oil and gas exploration and development companies.

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RESERVES
Mining industry reserve standards are defined under National Instrument 43-101 (NI 43-101). The regulations only
permit mineral resources to be reported under the following specific resource categories:

NI 43-101 Resource Category Brief Definition

Inferred mineral resource Insufficient data to confirm continuity of resource

Indicated mineral resource Similar to inferred except there is sufficient data to give a reasonable
expectation of the mineralization’s continuity

Measured mineral resource Sufficient data are available to confirm continuity of the mineralization

Probable mineral resource Is the economically mineable portion of an indicated resource

Proven mineral resource Is the economically mineable portion of a measured resource

The mining company must strictly adhere to the methods prescribed and statistical tests and thresholds set out in
the regulation when they communicate their reserves to the public, regulators and stock exchanges. As a normal
course, reserves are upgraded to higher confidence resources with additional exploration activity and investment.
Understandably, equity markets, and lenders, assign progressively higher values to the higher confidence reserves.
Mineral exploration companies design their exploration activities with this in mind, especially as they approach the
time to decide whether a property should be developed into an operating mine.

MAIN EQUITY VALUATION METRICS: PRE-PRODUCTION VERSUS PRODUCING

The main valuation measures utilized for mining companies varies somewhat based primarily on whether the
company is in a pre-production state or is currently producing.

PRE-PRODUCTION COMPANIES
Mining companies that are solely focused on the discovery of mineral resources and/or the development of a
discovered resource, and are not capable of any metals production in the short- to intermediate-time period, are
generally referred to as being in their exploration and development phase.
Cash flow- or earnings-based equity valuation measures are not applicable to these companies since their current
focus on exploration and development activities, and lack of product sales, invariably renders them cash flow
negative, and certainly without any anticipated sales or earnings in the short- to medium-term.
The primary equity valuation metric applied to early-stage mining companies is market value per ounce of resource
or reserve (MV/ounce). Due to their different inherent level of risk, different market values per ounce are applied
to the amount of resources and reserves reported by the company in each respective OSC-defined resource or
reserve categories. Those ounces included in the proven and probable reserve categories have the highest equity
market value per ounce, followed next by measured and indicated resources with a lower per ounce market value,
and finally the inferred resources having the lowest market value assigned per ounce. This resource-based valuation
metric is heavily relied on particularly for these mining companies that are in the exploration stage and/or have
become a take-over target.
For early-stage mining companies that are well into their development phase and have published an independent,
expert-prepared project feasibility analysis for their potential mine, the company’s valuation will shift to a focus on
an estimate of the company’s market price to net asset value per share (P/NAVPS). The net asset value calculation
for the potential mine is facilitated by the mine’s feasibility study as it incorporates operating and financial
information such as estimates for the mine’s capital cost, operating cost, start-up timing, annual production
volumes, life of mine, and overall project profitability at various future metal prices.

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CURRENTLY PRODUCING COMPANIES

Understandably, currently producing mines inherently have significantly less operational and financial risk compared
to companies in the pre-production stage and therefore the method of valuation differs to reflect this.
Mining companies that are currently in production have two primary operational and financial goals:
1. Maximize immediate cash flow: realized through the combination of higher revenue as a result of maximizing
current metal production volumes, and the accompanying reduction in marginal operating costs due to
improved economies of scale, and
2. Increasing their mineral resource and reserve base, and life of mine estimate: realized through continued
successful targeted exploration activities.

In accordance with these two main goals, equity valuation for currently producing companies focuses on:
a. A cash flow-based valuation metric: with economic value/earnings before interest, taxes, depreciation and
amortization (EV/EBITDA) being the most frequently used cash flow-based metric, and
b. A present value-type of metric: with P/NAVPS being the most popular.

Many mining industry analysts utilize a uniquely-weighted combination of these two metrics in order to develop a
target market price for a particular company’s stock. This valuation methodology implies that equity market prices
for producing mining companies is driven by both the ability of the company to produce their product profitably and
also the ability to grow the value of the company by increasing the size of the company’s resource base successfully
and economically.
The cash flow metric (EV/EBITDA) indicates the degree of the mining company’s operational efficiency. This
efficiency measure is important since strong cash flow generation capability is critical to the company’s ability to
finance the potential growth of its operations in the future, as well as its ability to return capital to shareholders
through future dividend payments and/or share repurchase programs. Strong cash flow generation also reduces the
potential need for the company to access the capital markets, perhaps at an inopportune time, in the future.
The present value metric (P/NAVPS) reflects the degree to which the company can grow its resource size
economically. This is important since mines are depleting assets and it is critical that the company be able to extend
its operational life (commonly referred to as “life of mine”) as much as possible – thus increasing the value of the
company in present value terms.

NET ASSET VALUE

Investors in resource-based companies value reserve growth over time, provided that this growth is done in an
economic manner that will benefit shareholders. Accordingly, investors want to ensure that the price paid for new
or additional reserves is reasonable; whether done through organic growth (i.e. exploration activities) or through
corporate or asset acquisitions. Reserves normally play the most important role in the calculation of the net asset
value (NAV) and net asset value per share (NAVPS) for the company.
In a similar manner to book value, NAV considers the present value of all after-tax cash flows from the reserves over
time. It is critical that the analyst discern whether the NAV calculation is based on existing resources or whether it
includes the present value of cash flows from expected future exploration activity. These cash flows are normally
discounted at a rate of 10% but analysts often also run sensitivities at discount rates above and below 10% as they
deem necessary.
NAVPS is frequently used to value resource-based companies in the same way that analysts generally use a
discounted cash flow valuation for an industrial or consumer products company.
There are eight basic steps to create a net asset value model:
• Make assumptions for reserves, production volumes, commodity prices, future operating costs and discount
rates (with a discount rate of 10% per annum used in the base case)

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• Project production volumes and realized prices for commodities over time horizon
• Make operating expense and tax assumptions
• Calculate annual after-tax cash flows
• Calculate the net present value (NPV) of the annual after-tax cash flows
• Value other assets (note that only producing assets have been included in the calculations so far. At this point
the value of such assets as undeveloped land must be estimated and added to the NPV.)
• As the NPV is essentially the EV at this point in the calculation, it is necessary to make the appropriate
statement of financial position adjustments such as adding cash and subtracting debt. It is then possible to
calculate the equity value – and the implied per share price (NAVPS).
• A table of sensitivities to the NAVPS can now be created based on different commodity price scenarios or other
model input assumptions (the calculations in the table are beyond the scope of the IMT course).

An example of a typical NAVPS sensitivity table for a hypothetical Canadian gold mining company is as follows:

EXAMPLE
NAVPS Sensitivity
NAVPS (C$/share)
Long Term Gold Price Assumption (US$/oz.)
1050 1200 1350 1500 1650
0% Discount 5.94 6.92 7.90 8.88 9.86
5% Discount 4.31 4.92 5.53 6.14 6.75
10% Discount 3.36 3.76 4.16 4.56 4.96
15% Discount 2.77 3.04 3.32 3.59 3.86

In this sensitivity table, the NAVPS is provided for various gold bullion prices ranging from US$1,050/oz. to
US$1,650/oz., and for various discount rates ranging from 0% to 15%. For example, the $4.56/share number
represents the NAVPS for the stock at an US$1,500/oz. gold bullion price and a discount rate of 10% per annum.
The table is intended to show how sensitive the NAVPS is to changes in these two variables.

EQUITY VALUATION LESSONS LEARNED DURING THE NEW MILLENNIUM PRECIOUS

METALS BULL MARKET
Since the early 2000s, the underperformance of the precious metals common stocks as compared to the precious
metal commodity price movements is primarily attributable to three main factors which were essentially
underappreciated or ignored by most common stock investors. These three factors are:
1. Rapidly escalating capital and operating costs
2. Decline in mine head grade
3. Incorrect (or too narrow) measurement of cost of production

RAPIDLY ESCALATING CAPITAL AND OPERATING COSTS

The commodity-related industries are generally understood to be cyclical in nature with the timing of capital
investment attempting to capture the often powerful upward swings in commodity prices brought on by periods of
economic revival and associated price inflation. Unfortunately, this is often followed by an equally abrupt fall of in
commodity prices, and the financial fortunes of the commodity producers – and their investors.

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The 1990’s were characterized as a period of low inflation and stagnant-to-declining commodity prices. This
resulted in a decade-long period of negligible capital investment in the mining industry in general, and the precious
metals industry in particular. The pro forma economics of capital investment in new precious metals mines was
not supportable with US$250/ounce gold bullion prices. This, in turn, also translated into declining investment in
productive capacity in related industries that supported mine maintenance and new mine construction such as ore
drilling and ore transportation equipment. Furthermore, the metals bear market was so severe that many qualified
trades persons and skilled miners left the mining industry for other industries that offered potentially better
employment opportunities. This environment also discouraged many younger individuals from entering the mining
and related industries as a career due to perceived poor future employment prospects.
However, the commodities price boom that began in the early 2000s led to very rapid capital expansion plans in the
mining industry on a global basis and over all types of mining-related commodities ranging from precious metals
and base metals, right through to potash and uranium. This demand quickly led to rapid cost increases for all types
of materials and services that are required to both build and maintain mines. This cost escalation was exacerbated
by the underinvestment that had occurred in the 1990s as noted above.
Capital cost estimates on multi-billion dollar mining projects were revised upward almost on an annual basis as
project planners tried to reflect the increasing cost of inputs.
Operating costs were also impacted as many of the products and services required to operate a mine are the same
or very similar to the ones needed to construct a new mine. Some mining analysts have estimated that the total
global gold mine and mill operating costs have increased (on an annual compound percentage basis) at an amount
just slightly below the average annual compound percentage price change in the price of gold bullion since the
early 2000s.
However, these rising costs were for the most part neglected, or downplayed, as the rapidly rising precious metals
prices were assumed to outstrip the negative impact of rising capital and operating costs. These cost increases were
material over time and retrospectively were seen as limiting the gross margin increase for the precious metal mining
industry overall.

DECLINE IN HEAD GRADE

Head grade is the average grade of the ore at the face (or “head”) of the mine. In the precious metals mining
industry, head grade represents the concentration of gold or silver in the mine’s ore that will be sent to the mill
for processing and precious metals recovery. It is generally measured and expressed in the following units: grams/
tonne, ounces/tonne, or parts per million (ppm).
The primary economic benefit of higher grade ore is that that less ore must be mined and milled in order to recover
an ounce of gold or silver. This is critical to mining economics since the cost to mine and mill a tonne of ore is the
same regardless of the amount of precious metal contained in the tonne of ore.
Furthermore, head grade has an inverse relationship with the cost to mine and accordingly the gross margin. The
relationship between average mine head grade, total mine and mill operating costs, and gross margin per ounce of
gold produced is shown in the table below.

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Average Gold Total Operating Cost to Recover Pre-tax Profit**

Head Grade One Ounce of Gold* (US$/Ounce) (US$/Ounce)
Grams/Tonne Ounces/Tonne
4.0 0.13 310 990
3.0 0.10 415 885
2.0 0.06 620 680
1.0 0.03 1,240 60

* Assumes a total operating cost to both mine and mill one tonne of ore is US$40/tonne
** Assumes US$1,300/ounce gold bullion market price

Three important points must be considered when examining the table above:
1. Operating costs per tonne mined and milled more than doubled over the past decade, thus magnifying the
inverse relationship head grade and pre-tax profit relationship.
2. Pre-tax profits per ounce of gold produced are extremely sensitive to head grade especially at very low mine
head grades.
3. The average mine head grade for the global gold mining industry dramatically declined from almost 2.5 grams/
tonne in 2000 to an average of 1.3 grams/tonne by 2011. This mine head grade factor alone caused pre-tax
profits per ounce of gold produced to decline.

The decline in mine head grade over the past decade is primarily attributable to the inability of the gold mining
industry to replace its reserves with high grade ore. Furthermore this trend appears to be continuing into the present
day. This decline in gross margin per ounce of gold produced has dramatically impacted the precious metals mining
industry’s profitability and break-even gold price economics. Clearly, investors in mining companies must consider
the size of a mining company’s reserves and resources, but also the quality (head grade) in order to value the
company properly.

OPERATING COST DEFINITION

An accurate and clear definition of operating cost is crucial to the correct valuation of any company.
First, there is some ambiguity as to whether reported operating cost includes only all marginal cash costs associated
with operating a mine and mill (such as direct field and plant labour, fuel, maintenance and repairs, royalty
payments to governments and others) or whether it also includes additional cash and non-cash operating costs
including: general and overhead costs, gold/silver bullion hedging costs, and depreciation and amortization costs.
Inclusion of all three types of costs results in an increasingly utilized operating cost measure commonly referred to
as all-in-costs that provides a better measure of the company’s gross margin and overall efficiency of their current
operations.
Second, and perhaps more material, is the decision to include the following two specific types of cost in the
reported operating cost:
1. Exploration and development costs
2. Continuing capital costs

Precious metals mining companies often decide to capitalize portions of their exploration and development costs,
and thus potentially underestimate their total operating costs, despite the fact that some of these activities are
more closely related to supporting current/near term precious metals production volume rather than increasing the
company’s resources and reserves (which could be argued more successfully as addition to the firm’s assets).

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 CHAPTER 6 | ANALYSIS OF EQUITY SECURITIES II: COMPANY ANALYSIS AND VALUATION 6 • 33

In addition, some operating costs are capitalized despite the fact that they often reoccur year and after year which
raises the question as to whether they are more representative of ongoing annual operating costs rather than
statement of financial position items. These particular costs are referred to as continuing capital costs and represent
one of the main reasons why free cash flow to equity calculations are playing an ever-increasing role in fundamental
analysis and equity valuation of all capital intensive companies – including commodity producing companies.
These two particular cost items can be material, even when compared to the all-in-cost figure. Analysts reported
all-in operating costs for gold mining companies on a global basis at about US$1,200/ounce of gold produced in
2012. However, this cost figure increases to almost US$1,600/ounce of gold produced when continuing capital costs
and all exploration and development costs are included.

WHAT ARE THE LIMITS OF ACCOUNTING DATA?

At first glance, financial records of public companies give the appearance of precision and meticulousness. The
information flows nicely from the statement of comprehensive income to the statement of financial position and
from both of these to the statement of cash flows. All accounts balance and the entire package is normally audited
by a large multinational accounting firm and reviewed by the company’s board of directors.
In reality, not every accounting entry is based on an actual transaction and involves an exchange of actual cash.
The accuracy of a fair number of accounts relies on the judgement of the corporate auditor and management.
Management itself is given a wide berth by the accounting profession to exercise that judgement. All in all, investors
cannot take financial statements at face value.
Investors who perform fundamental analysis would be wise to arm themselves with the knowledge of what the
basic issues of accounting are, what motivates management to choose particular ways of handling accounting rules,
and how management can make financial statements show the company in the most favourable possible light.

THE ACCOUNTING ISSUES

Mergers and Activity in M&A has sharply increased in the last 35 years. In most cases, companies
acquisitions (M&A) have been bought out well in excess of their tangible net book value. The acquiring
company records the excess as goodwill as an asset on their statement of financial
position.

Disclosure and fraud As in all aspects of life, not everyone is completely ethical or honest. Since management
is in a position to make judgements to build financial statements, some push the
limits of accounting principles. To place their business in a more favourable light, some
managers may present financial results in a way that is misleading. Disclosure may be
less than complete. Notes and discussions may be vague. If a management team or one
manager pushes the limits too far, financial statements may be fraudulent.

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MOTIVATIONS FOR EXAGGERATING FINANCIAL RECORDS

Increased stock This is the most influential factor. Management has two avenues to increase the value
valuation of their company. One is to improve the operations of the business. The second is
to improve the appearance of the financial statements. For most investors, financial
records are the only portal to the actual performance of a company. Higher equity values
manifest themselves in several positive ways:
• Good financial performance and continued expectations of good performance secure
access to equity financing opportunities.
• The pricing of equity finance opportunities improves if the stock has a better
valuation. The company would give up less ownership based on a higher share price
and might be able to complete larger financings.
• Company managers receive stock options as part of their overall compensation.
A higher stock price leads to a greater option value.

Access to debt Institutional lenders rely on financial statements to ascertain a firm’s creditworthiness.
markets Managers may stretch results to maintain access to lenders and to keep the cost of
capital at a reasonable level. For instance, a small improvement in the credit rating of a
company can translate into several millions of dollars worth of saved interest cost.

Job preservation Steady growth in revenue and earnings keeps the board of directors pleased. A happy
board of directors means more job security for the company’s managers.

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 CHAPTER 6 | ANALYSIS OF EQUITY SECURITIES II: COMPANY ANALYSIS AND VALUATION 6 • 35

SUMMARY
By the end of this chapter, you will be able to:
1. Explain the difference between IFRS and GAAP.
• The major philosophical difference between the two accounting methodologies is that IFRS is almost entirely
principle-based whereas U.S. GAAP is primarily rules-based. Rules-based accounting is more rigid. In principle-
based accounting, guidelines are more general.

2. Identify the various sources of company information.

• Company information can be gathered from regulatory filings, conference calls, investor tradeshows, financial
records and other sources of information. There are four major parts of a company’s financial statements:
the statement of financial position, the statement of comprehensive income, the statement of changes in
equity (which provides a link between the statement of comprehensive income and the statement of financial
position), and the statement of cash flows.

3. Assess the quality of a company based on its earnings.

• A qualitative study of a firm’s business considers how the firm generates revenue and profit. A firm’s success
competing within its industry depends on its sustained competitive advantage.

4. List the merits of different absolute valuation models.

• Absolute valuation models make a point-in-time estimate of intrinsic value based on a set of forecast
company fundamentals.
• Dividend discount model: assumes a stock’s intrinsic value is equal to the present value of the stream of
future dividends. This model is suitable to valuing mature companies that pay dividends and have a dividend
payout consistent to its profitability.
• Discounted cash flow model: assumes a stock’s intrinsic value is equal to the present value of a stream of
future cash flow.

5. Assess the advantages and disadvantages of different valuation techniques.

• Price-to-earnings (P/E) is the most widely used multiple in the relative valuation method. P/E ratios are
uninformative when earnings are negative or very small.
• Price-to-book (P/B) ratio provides a method to finding undervalued companies. The P/B multiple is only useful
when examining capital-intensive firms or firms with plenty of tangible assets.
• Price-to-sales (P/S) ratio places a monetary value on each dollar of company sales. Revenue, unlike earnings
or even book value, is available even for the most troubled or cyclical of firms.

6. Calculate a firm’s worth using any of the valuation models.

• Dividend discount model:
D0 q 1 g D1
V0  
rg rg

• Price-to–earnings ratio:
Market price per common share P0
P E 
EPS of the last four quarters EPS0

• Price-to-book ratio:
P/B = (P0/BV0)

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7. Explain the metrics used in the analysis of oil and gas companies.
• Petroleum reserves are an important equity valuation parameter for oil and gas exploration and production
companies. The global unit measure of reserves for the oil and gas industry is the barrel of oil equivalent
(BOE). The most common production valuation metric for an oil and gas exploration and production
company is the economic value (EV)/barrels of oil equivalent per day (BOED). The most common reserve
valuation metric is the economic value (EV) per 1P or 2P reserves. The reserve life index (RLI) represents
the number of years it would take to deplete the existing reserves at the current daily production rate. The
recycle ratio measures operational profitability and exploration cost efficiency combined. The debt-adjusted
cash flow is used in the evaluation of oil and gas companies.
8. Calculate the metrics used in the analysis of oil and gas companies.
• Calculations used in the analysis of oil and gas companies include: economic value (EV), reserve life index
(RLI), field netback, recycle ratio, and debt-adjusted cash flow (DACF). DACF is used in the calculation of
DACF/Share and EV/DACF.
9. Explain the metrics used in the analysis of mining companies.
• The primary equity valuation metric applied to early-stage mining companies is market value per ounce of
resource or reserve.
• For early-stage mining companies that are well into their development phase, a market price to net asset
value per share can be used for equity valuation.
• For producing mining companies, equity valuation focuses on a cash flow-based metric (economic value to
earnings before interest, taxes, depreciation and amortization) and a present value type of metric (market
price to net asset value per share).
10.Explain the limitations of financial statement analysis.
• The accuracy of a fair number of accounts relies on the judgement of the corporate auditor and management.
Management is given a wide berth by the accounting profession to exercise that judgement. All in all,
investors cannot take financial statements at face value.

© CANADIAN SECURITIES INSTITUTE (2017)

Analysis of Equity Securities III:
Technical Analysis 7

CONTENT AREAS

What Are the Basics of Technical Analysis?

What Is Chart Analysis?

What Is Statistical Analysis?

What Are Sentiment Indicators?

What Is Intermarket Analysis?

How Can Technical Analysis Be Used?

How Can Technical Analysis and Fundamental Analysis Be Used Together?

LEARNING OBJECTIVES

1 | Use chart patterns to assess a stock.

2 | Assess stocks using statistical analysis and sentiment indicators.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7•3

INTRODUCTION
In many ways technical analysis is the foil to fundamental analysis. While fundamental analysis can be thought of
as the study of the supply and demand factors of a market, technical analysis can be considered as the study of the
cumulative effects of these factors on current and past market activity.
Market activity encompasses the three primary sources of information: price, volume, and time. In this chapter,
we’ll look at the use of price charts as the central form of technical analysis. Also we will look at two other forms
of technical analysis, statistical analysis and sentiment analysis. Finally we’ll examine the study of the price trend
relationships between different securities, called intramarket analysis, to indirectly forecast price movements of
specific securities.

WHAT ARE THE BASICS OF TECHNICAL ANALYSIS?

Technical analysis is based on three assumptions:
1. All influences on market action are automatically accounted for or discounted in price activity. Technical analysts
(technicians) believe that all known market influences are fully reflected in market prices. They believe that
there is little to be gained by doing further fundamental analysis; all that is required is to study the price action
itself. By studying price action, the technical analyst attempts to determine and measure market sentiment
and expectations. In effect, technicians let the market “do the talking,” indicating the direction and the extent
of the next price move.
2. Prices move in trends and those trends tend to persist for relatively long periods of time. Therefore, the primary
task of a technical analyst is to identify a trend, preferably in its early stages, and carry positions in that
direction until the trend reverses itself. This is not as easy as it sounds.
3. The future can be found in the past. Technical analysis is the process of analyzing historical prices to determine
probable future prices. Technicians believe that markets essentially reflect mass psychology and that the
behaviour of the masses (or the crowd) tends to repeat itself. Crowd behaviour fluctuates between pessimism,
fear, and panic on the one hand, and optimism, greed, and euphoria on the other. By comparing current crowd
behaviour, as reflected in market action, with comparable historical market behaviour, technicians try to
predict a reasonable outcome. If history does not exactly repeat itself, technical analysts believe that, at the
least, a lot can be learned from the past.

TECHNICAL VERSUS FUNDAMENTAL ANALYSIS

One common misconception about technical analysis is that its proponents believe the fundamentals of a stock
do not affect the price of the stock. This is far from the truth. Technical analysis is really an indirect study of
fundamentals. The basic difference between technical and fundamental analysis is that the technical analyst studies
the effects of changing fundamentals – that is, price and volume over time – while the fundamental analyst studies
the causes of price movements.
So, no matter what influences are driving the market, technicians believe they are all reflected in price action.
Fundamental analysts try to understand all the influences and attach a price forecast based on that information.
Technical analysts assume fundamental analysts have done their job, and that there is nothing to be gained from
further study of fundamentals, because all known market influences are already reflected in prices. All that is left to
do is study market action. Technical analysts understand that supply and demand forces cause prices to fluctuate;
they just do not believe that knowing the precise nature of those forces adds much to the forecasting process.

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7 •4 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 4

For instance, a fundamental analyst may suggest that a bull market in equities will continue because interest rates
are falling, while a technical analyst might say that new highs in equities are likely to continue because of the bullish
momentum in the bond market. Or a fundamental analyst might lower earnings expectations after a company
warns of poor revenue as a result of its negative currency exposure in Southeast Asia, while a technical analyst
might see a downward shift in the price of that stock and suggest selling.

WHAT IS CHART ANALYSIS?

Technical analysis is practised under four disciplines: chart analysis, statistical analysis, sentiment analysis and
intramarket analysis. Chart analysis, the most commonly used of the four, is the study of price movements of a
security over a specific period of time, which technical analysts believe can then be used to forecast where prices
are headed. The basic tool of chart analysis is the price chart. Price charts can be shown with the volume of trades to
compare it with the price action. Technicians typically look for volume to confirm or refute significant price moves
such as breakouts. In general, price charts:
• Illustrate price history in a concise and readily understood way;
• Help identify repetitive price patterns and potential price changes as a result of those patterns;
• Help determine entry and exit points that provide relatively high-reward, low-risk trades;
• Help an investor be more mechanical and objective (i.e., less emotional) when trading.

The bar chart is the most common type of price chart. Other popular types include line and candlestick charts.

TYPES OF PRICE CHARTS

BAR CHARTS
The bar chart plots price on the vertical axis and time on the horizontal axis. The activity in each period (hour, day,
week, month, etc.) is represented on a vertical bar, with the top of the bar representing the highest price for that
period and the bottom representing the lowest price.
The bar chart is also known as an open, high, low, close (OHLC) chart. In addition to the high and low for the period
represented, the opening price is represented by a short horizontal line to the left of the vertical bar, and the close
by a line to the right.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7•5

Figure 7.1 | Daily Bar Chart S&P 500

A daily bar chart of the S&P 500 Index from February 7 to June 7.

Chart courtesy of StockCharts.com

Although bar charts are the most commonly used charts, two others are also used: line and candlestick charts.

LINE CHARTS
Line charts track a single value only, usually the closing price, rather than the four values contained in the standard
bar chart. Since most technicians want to know all four pieces of information, line charts are rarely used to track
primary price data. They are used, however, to chart statistical indicators such as moving averages and a wide
variety of oscillators. (Moving averages and oscillators are discussed later in this chapter.)

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7 •6 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 4

Figure 7.2 | Daily Line Chart S&P 500

This line chart covers the same time period as the chart in Figure 7.1. Line charts display information about closing
price levels, not intraday action.

Chart courtesy of StockCharts.com

CANDLESTICK CHARTS
Candlestick charts use one of the oldest known charting techniques, which originated in Japan in the early 17th
century. Like bar charts, candlestick charts record the open, high, low, and closing price for each period. The main
difference between the two is that the candlestick for each period has a real body, that is, a box that visually
represents the difference between the period’s opening and closing prices. When the closing price is higher than the
opening price, the real body is white or empty; when the closing price is lower than the opening price, the real body
is black or filled in. The colour of the real body plays an important role in interpreting candlestick charts.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7•7

Figure 7.3 | Daily Candlestick Chart S&P 500

This candlestick chart covers the same time period as the charts in Figures 7.1 and 7.2.

Chart courtesy of StockCharts.com

CHART PATTERNS
To forecast where a stock is headed, technicians look for certain patterns that are known to predict price
movements fairly reliably. They use these patterns to identify buying and selling prices, as well as price targets. This
section highlights some of the most popular patterns used in technical analysis, shown on bar charts.
We must emphasize that no single technical analysis tool is infallible. Technicians should always seek corroborating
evidence to support any decision made with a single technical analysis tool, including the identification of a chart
pattern.

TRENDLINES
One of the principles of technical analysis is that prices move in long-term, intermediate, or short-term trends. The
trendline is used to determine trends. A trendline is a line connecting a series of ascending lows (an up trendline)
or descending highs (a down trendline). Although it can be drawn by connecting just two points, a third point is
needed to confirm that the trend is valid.

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Figure 7.4 | Short term corrections within a Longer-Term upward Trend

Gold corrected down to the primary trend line several times from 2009 to 2011.

Chart courtesy of StockCharts.com

Once a trendline assumes a certain slope, that slope tends to persist. Therefore when technicians notice an up trend,
for example, they may consider a price decline to, or near, the trendline as a buying opportunity. If a stock trades
below an up trendline or above a down trendline – a situation referred to as a break (or violation) of the trendline –
it may signal an end to the trend. There are two reasons that it is not a certainty that a break or violation signals
an end.
• The significance of the trendline must be determined before making a judgement on whether the violation is
valid. A trendline that has been intact for a relatively long time, has a moderate slope, and has been tested
several times is more valid than one that has been intact for a short period only, is quite steep, and has been
tested only a few times. The violation of a longer-term trendline is more likely to signal the termination of the
trend. Violating a shorter-term line may only indicate a slowing or pausing of the trend, and may result in a
return to the longer-term trendline (see Figure 7.4).
• The violation of a trendline caused by the passage of time is generally thought to be less significant than a
violation caused primarily by a significant price move.

Even if a long-term trendline that has been tested many times is finally violated, investors should use other
technical tools to confirm the break before buying or selling. For example, a break below an up trendline is generally
considered more significant if it is accompanied by a significant increase in volume and, perhaps, a change in a
moving average of the price (moving averages are discussed in the section on statistical indicators).

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7•9

SUPPORT AND RESISTANCE

Support and resistance levels are probably the most noticeable and recurring patterns on a price chart. The
most common support and resistance levels are the highs and lows of trading ranges. These levels are known as
horizontal support and horizontal resistance levels. Trendlines and moving averages can also act as support or
resistance levels.
A support level is the price at which the majority of investors sense value and are willing to buy more than the
holders of the stock (or short sellers) are willing to sell. As demand outstrips supply, prices tend to rise from support
levels.
A resistance level is the price at which investors believe the stock is fully valued or possibly even overvalued.
At this point, perceived return potential is limited and many holders of the stock (or short sellers) are willing to
sell. Because of the limited return potential, potential buyers are unwilling to buy. Prices tend to fall as supply
overwhelms demand.

Figure 7.5 | Varying Levels of Support and Resistance

The Euro index, for example, broke above the resistance level of $1.345 in January 2011 starting a new up trend. This
same price level ($1.345) proves to be key support in mid-February during a short term pullback. Now $1.38 was the
new resistance line, but by March, that level too had been broken and acted afterward as a support line.

Chart courtesy of StockCharts.com

Markets may trade for long periods between support and resistance levels. These levels define a range of equilibrium
between buyers and sellers. Sentiment is not strong enough either way to take the price above the resistance level
or below the support level. However, investor expectations and sentiment change eventually.

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7 • 10 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 4

EXAMPLE
The Dow Jones Industrial Average never rose significantly above the 1,000 level throughout the 1970s and the
early 1980s. Three times it came close, and three times it dropped back again. On the fourth occasion, however,
it broke through. As is often the case, a sharp upward price movement on increasing volume followed the
breakout. Once investors accepted the fact that the Dow could trade above 1,000, they aggressively moved into
the market.

Identifying support and resistance levels is important in trend analysis. A break under support or over resistance
may indicate the end or reversal of a long-term, intermediate, or short-term trend, or its continuation after a period
of sideways trading. When a stock moves above a resistance level or below a support level, this fact alone does not
necessarily indicate the end, reversal, or continuation of a trend. Technicians check to see if prices clear the support
or resistance level by a certain proportion, such as 3% for long-term trends, before they take action. This criterion is
imposed to avoid getting whipsawed by a false market trend. Getting whipsawed means taking a certain position
in anticipation of the market moving in a certain direction, only to have the market reverse and go in the opposite
direction.

REVERSAL FORMATIONS
Trendline violations are not the same thing as trend reversals. A trendline can be violated without the trend
reversing. In most cases, the violation indicates that the previous trend has come to an end. What often follows is a
period of sideways trading. This may lead to a reversal of the previous trend or to a new trend in the same direction
as the one that ended.
Reversal formations are price or chart patterns that help confirm whether a trend reversal has taken place. We
discuss three of the more significant reversal formations in this section. Continuation patterns, on the other hand,
can help identify if a previous trend (which has ended) is likely to resume after a period of consolidation. Some of
the most common continuation patterns are discussed in the section immediately after reversal formations.

HEAD-AND-SHOULDERS FORMATION
Some reversal formations take weeks or even months to develop. One such formation, the head-and-shoulders
(H&S) formation, gets its name from its similarity to a human head and shoulders silhouette. When this formation
appears at the end of a bull market, it is called a head-and-shoulders top. When it takes place at the end of a bear
market, it is known as a head-and-shoulders bottom or inverse head and shoulders.
The first phase of an H&S top is the development of the left shoulder. It typically takes place after a long, sustained
bull market and initially appears to be a continuation of the upward trend. Volumes are typically strong. Eventually,
the left shoulder rally comes to an end and a price correction follows.
After the correction runs its course, the head begins to develop. Prices rally strongly past the peak of the left
shoulder and move to new highs. Volume during the rally is relatively low, which is a sign that the bull market
may be weakening. A second warning signal comes as the correction following this rally takes prices under the left
shoulder’s peak and usually under a key up trendline. The break of the trendline indicates that there is a good chance
the trend has moved from up to sideways.
After the head has formed, prices begin to rally again, accompanied by relatively low volume. Normally the peak
is well below the high attained by the head, so that the right shoulder rally may retrace one-half to two-thirds of
the rally that occurred during the formation of the head. At this point, a trendline can be drawn connecting the low
that formed at the end of the left shoulder and the low that followed the formation of the head. This is usually a
slightly upward-sloping line, although it can be flat or even slightly downward-sloping. This trendline is known as
the neckline.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7 • 11

For an H&S top formation to be complete, the price decline following the right shoulder peak must bring the price
well below the neckline. Volumes typically increase when the trend goes below the neckline.

Figure 7.6 | Head-and-Shoulders Top Formation

The head-and-shoulders formation was confirmed on the break below the neckline from the right shoulder in
August 2011. The market sold off severely on the break.

Chart courtesy of StockCharts.com

A decisive break of the neckline indicates that a trend reversal has probably taken place. The H&S top formation
even provides an approximation of the size of the downward price movement over time. After the neckline break,
the projected move would take the price below the neckline by an amount approximately equal to the vertical
distance between the neckline and the peak of the head.
An H&S bottom formation or an inverse H&S generally takes place after a long down trend.

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7 • 12 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 4

Figure 7.7 | Head-and-Shoulders Bottom Formation

A head-and-shoulders bottom formed in mid-2010 for iPath Copper Index ETF. After identifying the possible
formation in its early stages two different approaches could have been taken:
i. A buy stop could have been placed just above the neckline at $42 to enter the market on a break above this
level, with a protective closing sell stop being placed just below the neckline after the long position was
established.
ii. A trader could have waited for the break above the neckline and the possible correction back to the neckline,
then place buy stops slightly above the neckline and protective closing sell stops below the neckline after the
long position was established. It should be noted that the probabilities of a correction back to the neckline
highly diminish the more the neckline is downward sloping.

Chart courtesy of StockCharts.com

Although H&S formations are one of the more reliable trend-changing formations, they are subject to
interpretation. First, as with all formations, it is a mistake to try to anticipate the completion of a formation. A
pattern may develop that looks at first like an H&S top or bottom, but until the neckline is violated, the formation is
not confirmed.
Even if the neckline is violated and the formation is confirmed, there is no guarantee that subsequent price action
will behave as the formation suggests it will. An H&S top formation may fail because of a sharp upward rally fuelled
by investors who have been caught off guard by the sudden turn of events. Short sellers are forced to cover their
positions and investors who liquidated in anticipation of long-term price weakness jump back on board.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7 • 13

KEY REVERSALS
A key reversal occurs after a long move either up or down has taken place. It typically follows several days, or
even weeks, of sharp price movements in the direction of the prevailing trend. At the start of a key reversal, prices
continue to move strongly in the direction of the trend, reaching a new high (in the case of an uptrend) or a new low
(in the case of a down trend). By the end of the day, however, the price has closed lower (in the case of an up trend)
or higher (in the case of a downtrend) than the previous day’s close. If prices close lower than the previous day’s
low (in the case of an uptrend) or higher than the previous day’s high (in the case of a downtrend), the reversal has
even more significance and would be called an outside day. Volume on a key reversal day is normally very heavy, as
buying or selling power is finally exhausted.
A key reversal day or week (particularly an outside day or week) on heavy volume during the panic-selling phase of
a bear market or the panic-buying phase of a bull market provides a reasonable assurance that the preceding trend
has come to an end. Further confirmation occurs if and when the trendline is violated.

Figure 7.8 | Key Reversal

Chart courtesy of StockCharts.com

Double tops and bottoms are almost as common as head-and-shoulders formations. These formations resemble
the capital letter M (double top) and W (double bottom). Double tops and bottoms can be identified on daily,
weekly, or monthly charts. When they occur on a daily chart, they usually take about two months or less to develop.
Weekly or monthly double tops take much longer to develop and as a result have much greater significance.

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Double bottoms and tops are, generally speaking, more significant the longer the time between the tops or
bottoms.

Figure 7.9 | Double Bottom Formation

Figure 7.9 – South Korea iShares. The first bottom occurred in the last quarter of 2008. After a second test of the
lows in the first quarter of 2009, the market rallied through the resistance around $30. The measured move in a
double bottom formation is measured from the breakout level, and is equal to the distance between the double
bottom level and the breakout level (A to B). The distance from approximately $20 to $30 is $10. Add this to $30,
and the measured move is $40, which was hit in the third quarter of 2009.

Chart courtesy of StockCharts.com

CONTINUATION PATTERNS
Continuation patterns are an extension of the second assumption of technical analysis: prices tend to move in
trends that persist for relatively long periods. It is usually a mistake (often an expensive one) to anticipate a reversal
of the trend without significant technical corroboration.
Continuation patterns represent a pause on a price chart, typically in the form of sideways trading, before the
prevailing trend continues. These patterns are also referred to as a consolidation of an existing trend. They are quite
normal and are considered healthy in a trending market. If a trend continues too far too quickly without a pause, it
usually experiences a sharp, even violent reversal.
Unlike most reversal patterns, continuation patterns do not normally take very long to develop. This makes intuitive
sense. Weeks, months, or even years may be required for a trend to reverse itself, whereas continuation patterns
may exist for only a couple of days or weeks before the trend reasserts itself.
Sometimes the patterns are ambiguous. Some continuation patterns may turn out to be reversals and some reversal
patterns may turn out to be continuations. Close attention must be paid to other indicators, including volume and
the direction of the ultimate break of the formation.

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TRIANGLES
The most common types of continuation patterns are triangles. Triangles consist of a support line and a resistance
line that meet or are projected to meet at a point called the apex. The slope of the support and resistance lines
determines the type of triangle.

SYMMETRICAL TRIANGLE
The symmetrical triangle usually indicates a continuation but may occasionally indicate a reversal. In a
symmetrical triangle, the support and resistance lines are equal in length and slope, although the slope cannot be
horizontal (Technically, the slope of the resistance line is the negative of the slope of the support line). A gradual
and symmetrical narrowing brings the pattern to the apex, where volume and volatility tend to be very low.
There are no clear methods of distinguishing whether a symmetrical triangle represents a reversal or a continuation,
so close attention needs to be paid to volume. A breakout, particularly an upside one, should be accompanied by
high volume. If volume is high when the market breaks, there is a strong probability the market will continue in the
direction of the breakout. In this case, the signal given by the triangle, reversal or continuation, will be based on the
direction of the trend prior to the formation of the triangle.

Figure 7.10 | Symmetrical Triangle

A symmetrical triangle formed over three weeks from October 26 to November 13, with a break to the downside
on November 16. Two different potential measured moves are shown as lines A and B extending down from the
breakout.

Source: CQG, Inc

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The closer the price gets to the apex, the more each market move must be scrutinized. Often the price will move
falsely outside the narrowing range of the pattern without a high volume pattern to confirm the market’s new
strength. If the price does not continue the previous trend within a few days of the breakout, the pattern is likely to
fail and the price will probably reverse quickly through the opposite end of the pattern.

ASCENDING TRIANGLE
Ascending triangles are bullish patterns that have a horizontal resistance line and a positively sloped trend line
acting as support. They normally indicate a reversal in a bear market and a continuation in a bull market. Although
they occasionally give the wrong signal, they are more predictable than symmetrical triangles. Volume is not as
important with ascending triangles as it is with symmetrical triangles because the market is already showing a
positive trend with the higher lows of the ascending support line. If there is strong volume on a breakout in an
ascending triangle, however, it gives more weight to the formation.

Figure 7.11 | Ascending Triangle

An ascending triangle began forming after the lows in early October. Twice, resistance was met just above the 5350
level, and at the end of the chart was testing it a third time. If the market breaks the ascending triangle, a measured
move to about 6100 is possible.

Source: CQG, Inc

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DESCENDING TRIANGLE
Descending triangles are the opposite of ascending triangles. They consist of a horizontal support line and a
negatively sloped trend line acting as resistance. Descending triangles always indicate a reversal in a bull market and
a continuation in a bear market.

Figure 7.12 | Descending Triangle

A descending triangle began forming after the uptrend faltered in early October. Support held twice at around 2980
before breaking down in late November. The measured move to 2770 was reached in less than four weeks.

Source: CQG, Inc

WHAT IS STATISTICAL ANALYSIS?

Compared to chart analysis, statistical analysis is a relatively new form of technical analysis made possible by the
increased sophistication of computers. We will look at four statistical tools that indicate trends or momentum.
These tools can be used to confirm trends identified through chart analysis or to provide an early warning signal that
a particular trend is starting to lose momentum.
Although chart analysis may be somewhat subjective, statistical analysis is more objective. There are no shades of
opinion among market participants on whether a certain statistical indicator has changed because the data is the
same and the calculation of the indicator is the same. In contrast, disagreement often occurs over chart analysis on
issues such as whether a chart formation has been completed, whether the volume figures supported the breakout,
or whether the size of the breakout was adequate for a valid signal.

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TREND-FOLLOWING INDICATORS
Trend-following indicators are used to identify or confirm the existence of a trend. When the existence of a trend
has been established, these indicators help technicians determine the prices for buying or selling stock.

MOVING AVERAGES
Moving averages are the most widely used statistical indicator. Moving averages differ by type – simple, weighted,
or exponential – and by the number of days to be averaged.
A simple moving average is an arithmetic average of closing prices over the past “n” days. The price observations
are merely added up and divided by the total number of observations. The formula for the simple moving average is:
S S2 y SN (7.1)
Simple MA  1
N

where
P = closing price
N = number of observations

EXAMPLE
Let’s say the price of a stock for the past five days was:
Day 1 $70
Day 2 $68
Day 3 $66
Day 4 $67
Day 5 $68

The 5-day moving average would be $67.80. If the price closed at $69 on Day 6, Day 1’s price would be taken out
of the calculation and Day 6’s price added so that the moving average would be $67.60.

A simple moving average gives equal weight to each session’s price over the period. By comparison, the weighted
moving average and the exponential moving average give more weight to recent prices than they do to older
prices.
Moving averages help to isolate trends by toning down sharp fluctuations. When prices rise above the moving
average and the moving average is generally rising, the underlying price trend is considered to be up. When prices
fall below the moving average and the moving average is trending down, the underlying price trend is considered to
be down.
Choosing the appropriate number of days to average is a critical decision. It is usually made by examining how well
different moving averages identified turning points for a particular stock in the past. The most popular long-term
moving average is the 40-week (or 200-day) moving average. This indicator has a good track record in identifying
long-term trend changes for most stocks and stock indexes. Many investors pay close attention to the 40-week
moving averages of the stocks they follow. Of course, an investor who is taking a very short-term view of the market
and trading in and out on a more frequent basis will use a shorter moving average (such as 10 days).
One of the most basic uses of a moving average is to identify support or resistance levels. In a down-trending
market, the moving average acts as resistance; in an up-trending market, the moving average acts as support. Like
trendlines, a violation of a moving average in a trending market may signal an end to the trend.

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Long- and short-term moving averages can also be used on the same price chart. The shorter-term moving average
will be more sensitive to changes in the price of the stock than the longer-term moving average. A change in trend
from down to up is indicated when the shorter-term average crosses over the long-term average and both moving
averages rise.

Figure 7.13 | Using Two Moving Averages – Buy and Sell Signals

Both a 50-day and a 100-day moving average are displayed along with the price. Using a crossover system to
generate trade signals, a sell signal was indicated in mid-2010 followed by a buy signal in September 2010.

Chart courtesy of StockCharts.com

PRICE BANDS
While moving averages can be used to identify support and resistance levels, price bands, including Bollinger bands
and moving average envelopes, take that concept one step further.
John Bollinger popularized the technique in which the standard deviation of prices over a period of time is plotted
above and below a moving average of the prices.

EXAMPLE
The standard deviation of a stock’s price based on the most recent 20 periods would be plotted above and below
a 20-period moving average of the stock price.

These plots are known as Bollinger bands. Given the assumption that prices are approximately normally
distributed, a two-standard deviation band should capture approximately 95% of the price action, thereby
containing most range extremes. The price fluctuates between the two bands, finding support at the lower band
and meeting resistance at the upper band. The band widens as price volatility increases and narrows as volatility
decreases.

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Moving average envelopes (also known simply as envelopes) are plotted at a fixed percentage above or below a
moving average.

EXAMPLE
If the average historic weekly range (the average difference between the weekly highs and lows) for a particular
stock is 2%, then plotting the five-day moving average with an envelope at +/– 1% will capture most of a week’s
range of trading.

Obviously, moving average envelopes are most helpful in stable rather than highly volatile markets. Since fewer
and fewer markets seem to fit this description, Bollinger bands are much more widely used than moving average
envelopes.

MOMENTUM INDICATORS
While trends describe the general direction of prices, momentum measures the degree to which trends are
accelerating or decelerating. Thus, while a stock may be in an up trend, the up trend may be slowing, indicating
that it may be about to end. Technicians have developed several indicators to measure momentum. Three of the
most popular momentum indicators are moving average convergence-divergence (MACD), stochastic, and relative
strength index (RSI).
Before these indicators are reviewed, the concept of an oscillator should be explained. An oscillator is an indicator
that fluctuates between two values. There are two classes of oscillators: one class fluctuates between two fixed
values and the other is not bound by fixed values. The stochastic and RSI oscillators are bound between two fixed
values; the MACD is not (theoretically, it can keep rising or falling forever, although in most cases it remains within a
certain range). Momentum oscillators can be used in three ways:
• Like moving averages, momentum oscillators can be used to generate buy and sell signals whenever the
oscillator crosses a moving average of the oscillator or when the oscillator moves above or below a specific
level.
• They can be used to indicate overbought and oversold levels. When the oscillator moves to an extremely high
value within its fixed or normal range, it may indicate an overbought level. When the oscillator moves to an
extremely low value, it may indicate an oversold level. On its own, however, this information can be misleading.
A technician that bought every time an oscillator indicated that the stock is oversold and sold when it indicated
the stock is overbought would undoubtedly sustain losses. Like other technical analysis tools, the decision to
buy or sell should reflect more than one indicator or chart pattern.
• Momentum oscillators can also be used in divergence analysis, whereby a shift or change in momentum can be
identified if the momentum oscillator differs from the price action. For example, if the price of a stock reaches a
new high but a momentum oscillator does not, this may signal that the new high is unsustainable and the price
may decline. Similarly, if a stock has a strong up trend but a momentum oscillator is displaying a down trend,
this may signal that the up trend is about to end.

MOVING AVERAGE CONVERGENCE-DIVERGENCE INDICATOR

The MACD indicator is probably the most popular indicator for tracking momentum and conducting divergence
analysis. The MACD indicator is equal to the difference between a short-term and longer-term exponential moving
average (EMA).

EXAMPLE
If the 12-day EMA for a stock is $24 and the 26-day EMA for a stock is $26, then the MACD is –2.

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The MACD oscillator makes a lot of sense if you think about it in the following terms. By taking the difference
between two moving averages, you are measuring a shift in trend over a period of time – in other words, a measure
of momentum. If, for instance, the difference between a 12-day moving average and a 26-day moving average is
positive and is increasing over time, then the 12-day moving average is rising faster than the 26-day moving average
and the MACD is rising. This must mean that the stock price is rising and that the rate of recent price gains is greater
than the rate of previous price gains. This implies positive price momentum.
In practice, the MACD line is usually accompanied by a signal line representing an exponential moving average of
the MACD line. Usually, the MACD line measures the difference between a 12- and a 26-period EMA, which is then
smoothed by a nine-period EMA of the MACD line.
The MACD indicator is typically used in two ways: crossovers and divergences. In crossover analysis, buy signals are
generated whenever the MACD line rises above the signal line (the EMA of the MACD line) from below, and sell
signals are given whenever the MACD line falls below the signal line from above. In divergence analysis, buy and
sell signals are generated whenever action in the MACD oscillator differs significantly from action in the price of the
stock itself.

STOCHASTIC
The stochastic indicator is a good tool for assessing the quality of market moves. When a stock is trending higher,
its daily close tends to be near the highest price reached during the session; when it is trending lower, its close tends
to be near the lowest price reached during the session. These are strong characteristics of a trending market. The
stochastic indicates whether the market is closing near its highs and lows.
Like the MACD, the stochastic indicator is typically used in conjunction with a smoothed average. Unlike the MACD,
the smoothed average is not technically a moving average, but a different type of average.
The standard period covered by the stochastic indicator is five days, but it can be easily modified to suit each
investor’s time frame. A shorter period is more sensitive and will capture less significant market moves, whereas a
longer period, such as 14 to 21 days, would capture more significant moves. There is no correct time period to use;
the choice depends on the time frame within which the investor is analyzing or trading.
The stochastic indicator is used to generate buy and sell signals based on crossovers, to identify overbought and
oversold levels, and to conduct divergence analysis.

RELATIVE STRENGTH INDEX

The RSI measures momentum by comparing the relative strength of price gains on days that a stock closes up to
the strength of price declines on days that a stock closes down. Like the stochastic oscillator, the premise behind the
RSI is that a stock should close strongly when it is rising and weakly when it is falling. RSI is calculated by looking
at the past 14 days of price action. However, any number of periods can be used, depending on how sensitive the
technician wants the indicator to be. Shorter time frames (five to nine days) capture shorter-term moves and longer
periods capture longer-term moves.
Like the stochastic indicator, the RSI indicates overbought and oversold levels. The standard overbought range is
above 70 and the standard oversold range is below 30. Therefore, if the RSI is above 70, the RSI is indicating an
overbought level. Some markets seldom reach these extremes. A 14-day RSI reading of 80 tells us that the market
closed, on average, four times stronger on up days than it closed weaker on down days during that period. A 14-
day RSI reading of 80 is very strong. When a market remains above or below 50 for extended periods of time, it is
generally considered to be trending.

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WHAT ARE SENTIMENT INDICATORS?

Sentiment indicators focus on investor expectations, or their degree of bullishness or bearishness about a particular
stock or stock index. At first, it might seem that if a sentiment indicator implied that investors were bullish about a
stock, it would be a good time to buy the stock. In fact, sentiment indicators are almost always used as contrarian
indicators.
A contrarian indicator suggests buying a stock when most investors are bearish and selling a stock when most
investors are bullish. In other words, if the majority of investors feel strongly that prices will rise, a contrarian
investor behaves as if they will fall. The rationale is that if most investors feel that prices will rise then they probably
own the stock already so there are probably not enough investors left to push prices significantly higher. Contrarian
indicators are usually used as corroborating evidence to support other technical indicators. A variety of tools,
including the put/call ratio, bullish and bearish consensus, and public short ratio, can be used to measure overall
market sentiment.

PUT/CALL RATIO
The put/call ratio compares the number of put options traded during a trading session with the number of call
options. Recall from the Canadian Securities Course that put options can be used either to speculate on a price
decline or to prevent or limit losses (or protect profits) on a new or existing position. Call options, on the other
hand, can be used to speculate on a price increase. Therefore, the number of put options traded relative to the
number of call options traded (the put/call ratio) can indicate the degree of bearishness among investors. If the
ratio is rising (the number of puts traded is increasing relative to the number of calls traded), it suggests a bearish
market sentiment. Since the put/call ratio is used as a contrarian indicator, bearish market sentiment is considered
a bullish indicator. A falling put/call ratio suggests a bullish market sentiment and as a contrarian indicator would be
considered a bearish indicator.
When the put/call ratio reaches extreme levels, the market is considered to be either overbought or oversold. What
constitutes extreme is a matter of interpretation. If put/call ratios are normally around 60%, a ratio of 80% could
indicate overly bearish market sentiment, while a ratio of 40% could indicate an overly bullish market.

BULLISH AND BEARISH CONSENSUS

A number of American organizations, such as CONSENSUS INC., the American Association of Individual Investors,
and Market Vane Corp., construct consensus indicators based on the bullish or bearish leanings of market
participants and publish the results, usually to paid subscribers. CONSENSUS INC.’s Consensus Bullish Sentiment
Index of Market Opinion, for example, tracks the opinions of analysts at investment dealers as well as experts
who write independent market commentary letters. Market Vane Corp.’s Bullish Consensus report, on the other
hand, summarizes the opinions of commodity trading advisors that primarily trade futures contracts. In any case,
consensus information can be used as an early warning signal when the index is moving to an extreme level of
bullishness or bearishness.

PUBLIC SHORT RATIO

Some exchanges publish data on the total number of shares sold short, separated into two categories: those sold
short by stock exchange members and those sold short by the public. The basic premise is that the public is a less
credible short seller and tends to be wrong, particularly at market turns.
The public short ratio (PSR) divides the total short sales of the public by the total short sales. When the ratio is
high, it indicates that public investors are more pessimistic about future market gains relative to member firms. If
the PSR is high and public investors are more pessimistic then, as a contrarian indicator, this is thought to be bullish
and suggest strong market gains in the future.

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WHAT IS INTERMARKET ANALYSIS?

While evidence of individual market technical analysis can be found from the 17th or 18th century, the study of the
relationship between different markets using technical analysis, called intermarket analysis, has been a relatively
recent development. Intermarket analysis uses technical analysis to identify market trends and the correlation
between them. Thus a separate but related market is used to call turning points and trends in another market. There
are three basic relationships which intermarket analysts follow.

Stocks versus Bonds Bond prices normally move in the same direction as stock prices largely due to the
influence of interest rates. Falling interest rates are favourable for bonds and equities.
A key point to remember here is that the bond market (or prices) historically peaks and
bottoms before the stock market does.

Bonds versus Inflation is particularly bad for bond prices. Analysts closely follow commodity markets
commodities as a leading indicator of inflation. When commodity prices begin to trend higher – as
measured for example by the CRB Index, a widely watched composite of different
commodities – market participants look for emerging inflationary signs, which can lead
to central banks raising interest rates and thus lower bond prices.

Commodities versus Nearly all commodities globally are transacted in U.S. dollars. A weakening U.S. dollar
currencies benefits commodities and rising commodity prices put downward pressure on the U.S.
dollar. The Canadian dollar, reflecting the underlying resource-based economy, is highly
correlated to commodity prices. In general, a rising currency benefits a country’s stock
and bond markets, whereas a weakening currency benefits larger multinational stocks
more so than smaller-capitalization stocks less dependent upon international sales.

Intermarket analysis can be applied wherever there is an interaction among asset types. For example, gold
stocks may lead directional changes in gold bullion. If energy prices are truly peaking, oil exploration and seismic
information companies should feel the slowdown first. To see if there is an investment style shift in sentiment
developing, look at how a value index is performing relative to a growth index. Intermarket analysis can provide the
fundamental relationships linking asset classes and investment recommendations together. It takes some thinking
“outside of the box” to keep your investment outlook on track, but in this competitive world your clients will notice.

HOW CAN TECHNICAL ANALYSIS BE USED?

Technical analysis tools can be used to improve market timing, to forecast price movements, and to indicate turning
points before they occur (that is, to act as a leading indicator). These applications can be helpful to advisors who
recommend stocks or mutual funds to their clients.

MARKET TIMING
Fundamental analysts try to understand the micro and macro events that influence the supply and demand of a
stock. While having a solid understanding of these factors is important, it does not ensure successful market timing.
In fact, many fundamental analysts are poor market timers. We have probably all seen situations in which an analyst
has issued a strong recommendation to buy a stock at a certain price level, with a certain price target, only to see
the price of the stock fall (the common reaction to this situation is to remark that if the stock was a great buy at the
recommended price, it is an even better buy at the lower price).

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Difficulties with market timing arise because the market discounts information very quickly. The analyst may have
been correct in his or her analysis, but the market may have already priced in that same information. Another
possibility is that the analyst may be too far in front of the market. The forecast may come true in the long run, but
that doesn’t help the investor who has seen prices move, at least in the short term, in a direction opposite to the
forecast and has experienced a large loss.
One benefit of technical analysis concerns the timing of market entry and exit. Studying the fundamentals and
some long-term technical indicators can give an investor a sense of the long-term price prospects for a stock. This
can be the first step in the stock selection process. But when one gets to the point of deciding when and at what
level to buy or sell a security, technical analysis can be helpful.

PRICE FORECASTING
The stock market is a place where a company’s stock is transacted in a market influenced by crowd psychology and
the alternating emotions of confidence and fear, and, in extreme situations, greed and panic. The overall trend of
institutional money flowing into or out of the market is what affects stock prices. Charts, the technical analysts’
primary tool, can reveal at a glance the effect of market psychology on the flow of money into or out of a stock.
The true, or intrinsic, value of a stock is rarely known with certainty. The market price moves above and below the
intrinsic value (whatever it is), pushed by market psychology and pulled by the intrinsic value.
It would be difficult enough to forecast what a stock is worth or will be worth in the future if stocks were priced in a
perfectly logical fashion (that is, if their prices equalled their intrinsic value). The fact that stocks are not makes the
challenge of price forecasting that much more difficult. As the saying goes, a stock is rarely priced at what it is really
worth, but at what people think it is worth. Technical analysts believe that it is not enough to merely understand
the supply and demand fundamentals to come up with a price forecast. How the crowd will react is also important
because a stock at any point is worth only what someone is willing to pay for it.
By studying past market behaviour and comparing it with current market action, technical analysis can help identify
trends and turning points, and project the extent of price movements through the analysis of price patterns and
breakouts from these patterns.

LEADING INDICATOR
Technical analysis assumes that all known information is discounted in security prices. Often, however, prices
move in a way that is inconsistent with known fundamentals. When this occurs, it can be taken as a signal that
the market is reacting to unknown fundamentals, for example, when the market starts to discount a change in the
fundamentals before the change actually takes place.
This happens quite frequently in the early stages of a bull or bear market, often in a dramatic and explosive fashion.
At this point, technical analysis tools can be used as a leading indicator, meaning the price action is essentially
predicting what will happen to fundamentals in the future. In the face of unusual price activity, market participants
who follow only the fundamentals may want to revisit their analysis.

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HOW CAN TECHNICAL ANALYSIS AND FUNDAMENTAL ANALYSIS

BE USED TOGETHER?
You may initially assume that both technical and fundamental disciplines are quite disconnected but in reality, that
is not the case.
Both the fundamental and the technical analyst need to know what they are trying to accomplish. When they figure
this out, they will realize they are probably trying to do the same thing which is to determine: will the security,
index, currency, or commodity under study go up or down? And when?
We know from our studies that both methodologies have strengths and weaknesses and so it may be prudent to
combine the two approaches in order to further support your bullish or bearish assumptions.
Let’s review a passage from the previous chapter relating to fundamental analysis:
“The Limits of Accounting Data
In reality, not every accounting entry is based on an actual transaction and involves an exchange of actual cash.
The accuracy of a fair number of accounts relies on the judgement of the corporate auditor and management.
Management itself is given a wide berth by the accounting profession to exercise that judgement. All in all,
investors cannot take financial statements at face value.”
Now let’s review a passage from the beginning of this chapter:
“Technical versus Fundamental Analysis
So, no matter what influences are driving the market, technicians believe they are all reflected in price action.
Fundamental analysts try to understand all the influences and attach a price forecast based on that information.
Technical analysts assume fundamental analysts have done their job, and that there is nothing to be gained from
further study of fundamentals, because all known market influences are already reflected in prices.”
Now we have a dilemma because a fundamental analyst cannot necessarily take financial statements at face
value and a technical analyst’s belief that “all known market influences” are already reflected in the price is flawed
because what if all known market influences are not correct?
If we reasonably assume that both methods have strengths and weaknesses then perhaps each approach could
compliment the other in order to provide better investment decisions than solely relying on one of these methods.
In other words fundamental analysis should be supported by some degree of technical analysis and technical
analysis should be supported by some degree of fundamental analysis. The following scenarios illustrate these
points:

SCENARIO ONE
A private investor or portfolio manager has an interest in three Canadian retail stocks but wishes to use only the
fundamentals of the retail group in order to make an informed investment decision.
Our fundamental analysis can use either a “top down” approach or a “bottom up” approach, or both.
A top down approach for the three Canadian retail stocks, Canadian Tire Corporation Limited, Dollarama Inc., and
Loblaw Companies Limited, might study factors such as consumer debt, demographics, competition and their
relative sensitivity to the business cycle.
The technical analyst may simply place the stocks into two distinct categories: Consumer Staples (Loblaw)
and Consumer Discretionary (Canadian Tire and Dollarama) and then study technical factors such as relative
performance or price momentum for these stocks.

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At this time, the technical work on the Consumer Discretionary sector is displaying early signs of relative out
performance over the Consumer Staples sector and therefore Loblaw was eliminated from the technical analyst’s
potential buy list.
If the fundamental analysis work also favours the Consumer Discretionary components we could now reasonably
assume that, at the moment, Canadian Tire and Dollarama may be better choices than Loblaw.
A bottom up approach on our three retailers would have the fundamental analyst examining the recent statements
of financial position and statements of comprehensive income in order to calculate the ROE (return on equity) and
traditional ratios such as the quick ratio, working capital ratio, debt to equity ratio, and gross profit margin. The
dividend yield, the dividend payout ratio and the price-earnings ratio would also be calculated.
The technical analyst has already eliminated one name and will instead apply studies to the two remaining names in
the Consumer Discretionary sector (Canadian Tire and Dollarama) using technical studies such as relative averages,
relative performance, price momentum, and pattern recognition.
At this time, technical studies determined that following a period of strength over the past 20 weeks both names
are displaying early signs of relative under performance versus their peer group. Therefore both names are rejected
for investment selections at this time.
At the same time the fundamental analyst may weigh the fundamentals for Canadian Tire and Dollarama and
conclude the valuations, while stretched, still remain favourable. However, upon review of the negative technical
work, the fundamental analyst may avoid a “buy” recommendation and attach a “hold” recommendation for
Canadian Tire and Dollarama.

SCENARIO TWO
Let’s say that over the last 12 months, TD Bank common shares have gone from the high end of their fair value to
the low end of their fair value and the stock price has declined 21%. For a fundamental analyst, historically, a P/E
ratio of 10-11 for TD Bank common shares is a good buying level, everything else being equal.
Technically, whenever TD Bank common shares are oversold (RSI under 30) this represents a possible buying
opportunity, however, the main trend remains down and each low is deeper than the last. The expectation is for
additional downward pressure as the stock rises towards its downtrend line.
Blending fundamental and technical analysis, a price around $68 is a level where fundamentals (P/E ratio of 11) and
technicals (RSI at 30) may meet and where the stock may start seeing some buying support, particularly if other
signals, such as a bullish MACD divergence (discussed earlier in this chapter), are evident.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7 • 27

Figure 7.14

Sources: StockCharts.com and Bloomberg Finance L.P.

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7 • 28 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 4

PROBLEMS WITH ONLY USING TECHNICAL ANALYSIS

EXAMPLE 1
A technician may be attracted to an “oversold” TSX retailer based on technical studies such as an RSI, or
a stochastic that imply a recent correction in the retailer’s stock price is a buying opportunity and not an
interruption of the longer term uptrend. A skilled retail analyst may have just learned that a large U.S. competitor
is looking for space in several key Canadian cities. This negative information could persuade the technical analyst
to postpone a purchase and wait to see if the correction extends to violate the current uptrend. Without the
information the fundamental analysis provides, which is new information not currently reflected in the price
action, the technical analyst could be blindsided.

EXAMPLE 2
A technician may be attracted to a TSX base metals miner based on technical studies such as an RSI, or a
stochastic that imply a recent correction in the base metal miner’s stock price is a buying opportunity and not
an interruption of the longer term uptrend. A skilled mining analyst may have learned the local government
is planning a sweeping change in environmental law which could shut down the company’s largest mine. This
negative information could also persuade the technical analyst to postpone a purchase and see if the correction
extends to violate the current uptrend.

PROBLEMS WITH ONLY USING FUNDAMENTAL ANALYSIS

Generally the problem with only using fundamental analysis is weakness in managing risk. We know that systematic
risk is the portion of a security or portfolio’s total risk that is related to fluctuations in the return on the overall
market. In other words a diversified portfolio’s returns are greatly related to the forces of bull and bear market
cycles. Systematic risk cannot be diversified away which leaves some form of technical market timing as the only
protection during bear market cycles.
Unsystematic risk (or specific risk) refers to a security’s price action that is not related to the fluctuations in the
overall market. Unsystematic risk is unique to each security in the portfolio with one or two big losers potentially
savaging our overall returns. It is rare for an analyst to review a company’s fundamentals and then issue a “sell”
before the stock has begun a significant decline and as such some form of a mechanical stop-loss or a hedging
strategy may be prudent for holders of the stock who are following a fundamental analyst.
In conclusion, it is important to understand the current market for every marketable security is based on the
meeting of market participants who disagree with each other (otherwise known as the bid price and the ask price).
If you as a portfolio manager or investor wish to compete with market participants, you need to use every analysis
tool at your disposal.

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 CHAPTER 7 | ANALYSIS OF EQUITY SECURITIES III: TECHNICAL ANALYSIS 7 • 29

SUMMARY
By the end of this chapter, you will be able to:
1. Use chart patterns to assess a stock.
• Types of price charts
« Bar chart: plots price on the vertical axis and time on the horizontal axis. The bar chart is also known as an
open, high, low, close (OHLC) chart.
« Line chart: track a single value only, usually the closing price, rather than the four values contained in the
standard bar chart.
« Candlestick chart: Like bar charts, candlestick charts record the open, high, low, and closing price for each
period. The main difference between the two is that the candlestick for each period has a real body, that is,
a box that visually represents the difference between the period’s opening and closing prices.
• Chart patterns
« Trendline: A trendline is a line connecting a series of ascending lows (an up trendline) or descending highs (a
down trendline).
« Support and resistance: A support level is the price at which the majority of investors sense value and are
willing to buy more than the holders of the stock (or short sellers) are willing to sell. A resistance level is the
price at which investors believe the stock is fully valued or possibly even overvalued.
« Head-and-shoulders formation: When this formation appears at the end of a bull market, it is called a head-
and-shoulders top. When it takes place at the end of a bear market, it is known as a head and-shoulders
bottom or inverse head and shoulders.
« Key reversal: A key reversal occurs after a long move either up or down has taken place.
« Double top and double bottom: These formations resemble the capital letter M (double top) and W (double
bottom). Double bottoms and tops are, generally speaking, more significant the longer the time between
the tops or bottoms.
« Symmetrical triangle: usually indicates a continuation but may occasionally indicate a reversal. In a
symmetrical triangle, the support and resistance lines are equal in length and slope, although the slope
cannot be horizontal.
« Ascending triangle: are bullish patterns that have a horizontal resistance line and a positively sloped trend
line acting as support. They normally indicate a reversal in a bear market and a continuation in a bull
market.
« Descending triangle: They consist of a horizontal support line and a negatively sloped trend line acting as
resistance. Descending triangles always indicate a reversal in a bull market and a continuation in a bear
market.

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2. Assess stocks using statistical analysis and sentiment indicators.

• Statistical analysis: is more objective than chart analysis.
« Trend-following indicators: are used to identify or confirm the existence of a trend.
• Simple moving average is an arithmetic average of closing prices over the past “n” days.
• Weighted moving average and exponential moving average give more weight to recent prices than they
do to older prices.
• Bollinger bands are a technique in which the standard deviation of prices over a period of time is plotted
above and below a moving average of the prices.
• Moving average envelopes (also known simply as envelopes) are plotted at a fixed percentage above or
below a moving average.
« Momentum indicators: momentum measures the degree to which trends are accelerating or decelerating.
• The moving average convergence-divergence (MACD) indicator is equal to the difference between a
short-term and longer-term exponential moving average (EMA). The MACD indicator is typically used in
two ways: crossovers and divergences.
• The stochastic indicator indicates whether the market is closing near its highs and lows. The stochastic
indicator is used to generate buy and sell signals based on crossovers, to identify overbought and
oversold levels, and to conduct divergence analysis.
• The relative strength index (RSI) measures momentum by comparing the relative strength of price gains
on days that a stock closes up to the strength of price declines on days that a stock closes down. The RSI
indicates overbought and oversold levels. The standard overbought range is above 70 and the standard
oversold range is below 30.
• Sentiment indicators: Focus on investor expectations and are almost always used as contrarian indicators.
« Put/call ratio compares the number of put options traded during a trading session with the number of
call options. If the ratio is rising (the number of puts traded is increasing relative to the number of calls
traded), it suggests a bearish market sentiment. Since the put/call ratio is used as a contrarian indicator,
bearish market sentiment is considered a bullish indicator. A falling put/call ratio suggests a bullish market
sentiment and as a contrarian indicator would be considered a bearish indicator.
« A number of American organizations, such as CONSENSUS INC., the American Association of Individual
Investors, and Market Vane Corp., construct consensus indicators based on the bullish or bearish leanings of
market participants that can be used as an early warning signal.
« Public short ratio (PSR) divides the total short sales of the public by the total short sales.

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 SECTION 5

DEBT SECURITIES

8 Debt Securities
Analysis of Debt Securities I: Valuation, Term Structure,
9
and Pricing
Analysis of Debt Securities II: Price Volatility and
10
Investment Strategies

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 Debt Securities 8

CONTENT AREAS

Why Invest In Debt Securities?

What Are the Characteristics of Debt Securities?

What Are the Risk Factors of Debt Securities?

What Are the Trading Mechanics of the Debt Market?

LEARNING OBJECTIVES

1 | Compare the features of various debt securities.

2 | List risk factors of various debt securities.

3 | Explain the mechanics of debt trading.

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INTRODUCTION
Governments, corporations, and many other entities borrow funds to finance and expand their operations. In
addition to bank lending and private loans, these entities also have the option of issuing debt securities into the
financial markets.
From an investor’s perspective, the purchase of a bond, Treasury bill (T-bill), or any other debt security essentially
represents the decision to lend money to the issuer. In doing so, an investor gains no ownership rights, as they
would with an equity investment; rather, they become a creditor of the issuer.
This chapter begins with a detailed discussion of the issuers, types, and features of Canadian debt securities. It
concludes with an overview of the mechanics of debt market trading.

WHY INVEST IN DEBT SECURITIES?

The unique characteristics of a lending arrangement make debt securities ideal investments for a number of reasons:

Income Investors receive interest income as compensation for the original principal amount of
the loan to the issuer of the debt security.

Safety The repayment of the principal amount of the loan, as well as the interest payable
on the loan, represent legal obligations of the issuer. Depending on the prospects for
repayment, debt securities can potentially be a safe place to park funds.

Diversification The risk and return of debt securities make them an obvious choice for diversification in
most portfolios, being an integral component in combination with other asset classes.

Returns Debt securities offer the potential to realize capital gains on the original investment
amount, above and beyond the interest payable.

Although the reasons to invest in debt securities in general are well understood, choosing the particular type of debt
security to invest in requires a good foundation of knowledge about this asset class.

WHAT ARE THE CHARACTERISTICS OF DEBT SECURITIES?

Debt securities trading in the market today come in a multitude of formats, reflecting widely different borrowing
needs as well as investor demands. Borrowers modify the terms of a basic debt security to suit both their needs and
costs, and to provide acceptable terms to various lenders.

ISSUERS
GOVERNMENT ISSUERS
GOVERNMENT OF CANADA
The largest borrower in the Canadian debt market is the Government of Canada, which issues the following
securities:
• Fixed-coupon marketable bonds
• Treasury bills
• Real-return bonds

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• Canada Savings Bonds

• Canada Premium Bonds

Unlike other types of debt securities, securities issued by the Government of Canada are not backed by specific
assets; rather, they are backed by the general credit of the government itself.

FEDERAL AGENCIES AND CROWN CORPORATIONS

Canadian federal agencies and crown corporations are enterprises set up by the Canadian Parliament as agents
of the federal government. Several of these agencies, including Farm Credit Corp. (FCC), Canada Mortgage and
Housing Corporation (CMHC), Export Development Canada (EDC), and the Business Development Bank of Canada
(BDC), are active borrowers in the Canadian debt markets.
These liabilities legally constitute direct obligations of the federal government.

PROVINCIAL GOVERNMENTS
Provincial governments are active borrowers in the Canadian bond market. Each Canadian province has different
borrowing needs, as represented by the following instruments issued in the market:
• T-bills
• Fixed-coupon marketable bonds
• Savings bonds

As with Canadian government guarantees, these securities are backed by the general credit of the issuing
government rather than by specific assets.

MUNICIPAL GOVERNMENTS
Municipal governments (including regions, towns, cities, and other forms of local government) are also active
borrowers in the Canadian bond market, although their borrowing needs are often much smaller than those of other
levels of government. As a result, they tend to bring smaller issues to market.
Municipalities have direct taxing authority over property and are usually required to maintain balanced budgets and
manage their finances conservatively. Most municipal bond issues in Canada are fixed-coupon marketable issues,
with no direct backing by specific assets; however, other variations and infrastructure-backed issues exist. Province-
wide municipal finance authorities may also raise money for groups of municipalities whose borrowing needs are
too small to allow them independent access to the market.

NON-GOVERNMENT ISSUERS
CORPORATIONS
The Canadian corporate bond market has evolved over the years and now constitutes a large and growing
component of the overall market. No longer limited to a select group of higher-quality issuers, this sector is now
larger than the provincial and municipal sectors combined and comprises a wide range of issuers of varying credit
quality. The types of issues brought to market vary significantly, both in terms of structure and guarantee, making
the corporate sector the most sophisticated in the Canadian marketplace.

ASSET-BACKED SECURITIES
Rather than being backed by the guarantee of a government or corporation, debt securities can also be backed
by a pool of financial assets and thus are known as asset-backed securities (ABS). Generally, they are created by
forming a collection or pool of mortgages (in which case they are known as mortgage-backed securities), credit
card receivables, automobile loans, or other debt obligations and sell shares or participation certificates in the pool.

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 CHAPTER 8 | DEBT SECURITIES 8•5

The perceived credit quality of the security can be enhanced by third-party guarantees, letters of credit, recourse to
the issuer, over-collateralization (the amount of assets securing the loan exceeds the amount of the loan), or senior/
subordinated issuance (whereby multiple classes or tranches of securities are issued, with senior securities having a
claim on the assets ahead of subordinated securities). More details on asset-backed securities are provided in CSI’s
Portfolio Management Techniques course.

FOREIGN BONDS AND EUROBONDS

Both foreign governments and corporations have raised capital in Canadian dollars by issuing debt securities.

Foreign bonds Are issued and sold in a domestic market by a non-domestic government or corporation.
They are structured like domestic bond issues and targeted at domestic investors.
For example, Rogers Cable Inc., a Canadian cable company, has issued U.S.-dollar-
denominated bonds in the U.S. market; these bonds are considered foreign bonds in
the U.S. market. The U.S. market is an important source of capital for both Canadian
governments and Canadian corporations. It also represents a popular investment choice
for Canadian investors to meet U.S. dollar investing needs.

Eurobonds Are issued in a foreign market and are denominated in a currency other than that of the
market where the bonds are issued. For example, the Province of Ontario has issued
Australian-dollar-denominated bonds in the Eurobond market.

ISSUING METHODS
The evolution of debt markets has led to greater investor demand for greater liquidity, and issuers have also looked
for cheaper and faster ways of bringing issues to market. Today, rather than physical certificates, most bond issues
around the globe are issued in a book-based format only, with depository, trade clearing, and settlement services
provided by participating debt-clearing providers. In Canada, the national provider of these services is the Canadian
Depository for Securities Limited (CDS).

GOVERNMENT OF CANADA
The Canadian government issues fixed-coupon marketable bonds and treasury bills at regularly scheduled auctions.
During an auction, only recognized government securities distributors are permitted to submit bids to the Bank of
Canada, which acts on behalf of the Department of Finance.
The debt securities are awarded on a competitive tender basis, whereby the amount won at the auction is based
on the bids submitted, which are accepted in rising order of yield until the full amount of the auction has been
allocated. The total amount of the bids, as well as the high, low, and average bid, are published. Bids are also
concurrently submitted on a non-competitive tender basis, whereby the bid is accepted in full and bonds are
awarded at the auction average.

PROVINCIAL AND MUNICIPAL GOVERNMENTS

New provincial and municipal bond issues are normally brought to market as bought deals. A group of investment
dealers takes on the liability of buying the entire issue and then selling or distributing it to investors. These new
issues normally include an allocation for retail distribution for which the issuer pays extra fees in the form of
commissions to investment advisors.

CORPORATIONS
Corporate entities issue debt by first filing a prospectus with the applicable securities regulator. Corporate deals may
be either bought deals or marketed deals whereby investment dealers attempt to pre-sell issues to clients before
bringing them to market. Unlike government issues, there may not be a retail allocation in corporate new issues

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because many corporations prefer not to pay the extra fee for the wider distribution. As a result, most corporate
issues are targeted specifically at the institutional market. Once new issues are established in the market, retail
investors can get access to corporate bonds in the secondary market.
Most new filings in the Canadian corporate bond market and most new issues in the Eurobond markets are
now brought to market under medium-term note (MTN) programs. Under an MTN program, issuers file shelf
prospectuses that allow them to issue a wide variety of securities, up to a maximum amount, over an extended
period of time. The benefit of an MTN program for the issuer is that the securities can be issued on very short notice
because there is no need to prepare a new prospectus each time an issue is brought to market. In most cases,
retail investors are not able to buy MTNs on a new-issue basis because of the commission structure. Under an
MTN program, issuers pay dealers less in underwriting fees, with no commission available to pay retail investment
advisors.

FEATURES
Every debt security represents a contract between a borrower (issuer) and a lender (investor). Each contract is
normally documented in what is known as an indenture, which outlines the features of the security, the obligations
of the issuer, and the rights of the investor under the contract. An indenture will specify, among other things, the
following variables:
• Amount
• Principal repayment provisions
• Interest payment provisions
• Options

AMOUNT
The size of the specific loan indicates how much the issuer must repay investors at maturity. This amount, known as
the principal or face value or par value, is denominated in a specific currency.

PRINCIPAL REPAYMENT PROVISIONS

The term of the loan over which the principal is repaid can vary from as short as one day or overnight to as long
as 30 years or more. Although the repayment of the principal amount usually occurs on the maturity date, other
principal repayment dates are possible. Repayment can take place according to an amortization schedule, in
which the principal is paid back in regular or semi-regular payments over the life of the security. Alternatively, the
borrower may be able to make early principal repayments.

INTEREST PAYMENT PROVISIONS

Most debt securities make specific interest payments, known as coupon payments, over the life of the security1.
The interest can be paid out in even amounts, known as fixed interest, or in variable amounts, adjusting in response
to changes in another benchmark or interest rates. Bonds with variable coupon rates are typically referred to as
floating-rate securities. Interest payment provisions may also take other forms:
• Coupon rates can change over time, according to a schedule (e.g., step-up bonds and most savings bonds).
• There may be no periodic coupon interest, thus interest can be compounded over time and paid on maturity
(e.g., zero-coupon bonds, strip coupons, and residuals).
• A rate of interest does not have to be applied and the loan can be compensated in the form of a return based on
future factors, such as the change in the level of an equity index, which are known as index-linked notes.

1
In this course, we assume semi-annual coupon payments unless otherwise stated.

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OPTIONS
Many debt securities have options embedded in their structure. Options give either the issuer or the investor the
right to perform some action at a later date.

CALL FEATURES
The most common option is the call feature, whereby the borrower has the right to buy back the issue at specified
times before the final maturity date. A standard call feature includes a schedule of the dates and prices at which
a borrower can buy back the issue. The first call date is usually a few years after the issue date, although it can be
sooner. The call price declines over time, so that it is more expensive for the borrower to call an issue earlier in the
call schedule.
Two special call features common in the Canadian market are worth special mention:

Fixed-floater bonds These bonds are frequently issued by Canadian banks and insurance companies to meet
specific capital financing needs. They offer a fixed coupon payment for an initial period,
usually five or ten years. After that time, if not called by the issuer, they become floating-
rate notes, with the coupon rate reset quarterly, normally at a full percentage point
above the yield of current three-month Bankers’ Acceptances (BAs). Because banks and
insurance companies can typically borrow at a floating rate roughly equivalent to the
three-month BA rate, these bonds have never been extended by the issuers beyond the
call date.

Canada yield calls This feature allows the issuer to call a bond at a price based on the greater of (a) par or
(sometimes known as (b) the price based on the yield of an equivalent-term Government of Canada bond plus
doomsday calls) a specified yield spread. Generally, this spread is less than the spread was when the bond
was issued and remains constant throughout the term of the issue. Therefore, if the bond
is called prior to maturity and yield spreads remained constant, bondholders benefit
from the narrower spread specified by the call. If the bond is not called before maturity
and spreads remain constant, the bond’s yield will closely track Canada benchmark
bond yields. If the underlying issue’s spread narrows to less than its Canada call spread,
bondholders would still receive the benefit of the spread narrowing, as reflected in its
increased value relative to the benchmark.

CONVERSION OPTIONS
Another common option embedded in debt securities is conversion. The owner of the security has the right to
convert the debt obligation to another type of security: either another debt security in the case of an exchangeable
bond or the common shares of the issuer in the case of a convertible bond. The conversion is normally at a set
price at or over a specified time period and essentially represents a call option on the new security (not to be
confused with the call feature discussed above) because the purchase cost is the redemption value of the debt
obligation being converted.

PUT OPTIONS
The next most common option feature in Canadian debt markets is the put option, whereby the holder has the
right to request repayment of principal from the borrower before maturity. These issues are commonly known as
retractable or putable issues.

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PRICE AND YIELD

All marketable debt securities have a price and a quoted yield. The price is usually the price per $100 of face value,
so that if a debt security has a price of, say, 95, it will cost $95 to buy $100 of face value. If an investor were to buy
$10,000 face value, it would cost $9,500 plus accrued interest, if any.
Given the price of a debt security, it is possible to calculate a yield for the security. For most debt securities, the
yield is known as the yield to maturity and is an approximate measure of the annual return on the security if it is
held to maturity.2 For example, if a debt security has a stated yield of 5% and the security is held to maturity, its
annual return is approximately 5%.
There is no single formula for calculating the yield of a debt security. Different segments of the debt securities
market use different conventions for calculating the yield. We examine some of these conventions in the next
chapter. Regardless of how it is calculated, the price of a debt security at any point in time is inversely related to its
yield. That is, all else being equal, the higher the price, the lower the yield; the lower the price, the higher the yield.
This is a fundamental property of all debt securities.

RANKING
In the capital structure of a corporation, an important consideration for debt holders is the order in which liabilities
are repaid in the case of bankruptcy and liquidation. Corporate liabilities are normally ranked in the following order:
1. First Mortgage Liabilities and Asset-Backed Securities: These liabilities are secured by fixed assets (such as
property) and have first right to claim that asset ahead of all other debtholders.
2. Secured Debt: These loans are made on the understanding that they will be given first preference in the case of
bankruptcy. This normally applies to bank debt, deposit notes, and other secured loans.
3. Unsecured Debentures: These debt securities are not secured and are backed only by the corporation’s
guarantee and protective covenants. Within this category there can be additional rankings between different
debt issues, such as senior and subordinate.
4. Capital Securities: This indebtedness ranks below all other indebtedness of the issuer but above equity
stakeholders. (Capital securities are discussed later in this chapter.)
5. Preferred Shares: These equity stakeholders have first claim on residual assets after all debt holders have been
repaid. Their claim is based on the original par value of the preferred share investment.
6. Common Shares: These are the final stakeholders in the company.

TYPES OF DEBT SECURITIES

MONEY MARKET SECURITIES
Money market securities are debt securities initially issued with terms to maturity of one year or less. There are
three primary types of money market securities actively traded in Canada: Treasury bills, bankers’ acceptances, and
commercial paper.

TREASURY BILLS
Treasury bills (T-bills) are the shortest-term marketable debt instrument issued by governments. They are
purchased by investors at a price less than their face value, with the difference between the purchase price and
maturity value representing the return to the investor.

2
For callable debt securities, the quoted yield sometimes assumes the bond will be called before maturity, and thus it measures the
approximate return to the call date. The same principle applies to putable bonds. See Chapter 9 for more on the quoted yield of callable and
putable bonds.

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T-bills trade in $1,000 multiples and are marketable, meaning they can be sold prior to maturity. Government of
Canada T-bills are issued by auction, with terms to maturity of approximately three, six, or twelve months.

BANKERS’ ACCEPTANCES
A bankers’ acceptance (BA) is a commercial draft (i.e., a written instruction to make payment) drawn by a
borrower for payment on a specified date. A BA is guaranteed at maturity by the borrower’s bank. As with T-bills,
BAs are sold at a discount and mature at their face value, with the difference representing the return to the investor.
They trade in $1,000 multiples, with a minimum initial investment of $25,000, and generally have a term to
maturity of 30 to 90 days, although some may have a maturity of up to 365 days. BAs may be sold before maturity
at prevailing market rates, generally offering a higher yield than Canada T-bills.

COMMERCIAL PAPER
Commercial paper is an unsecured promissory note issued by a corporation or an asset-backed security backed
by a pool of underlying financial assets. Issue terms range from less than three months to one year. Most corporate
paper trades in $1,000 multiples, with a minimum initial investment of $25,000. Like T-bills and BAs, commercial
paper is sold at a discount and matures at face value.
Commercial paper is issued by large firms with an established financial history. Rating agencies rank commercial
paper according to the issuer’s ability to meet short-term debt obligations. Commercial paper may be bought
and sold in a secondary market before maturity at prevailing market rates and generally offers a higher yield than
Canada T-bills.

YIELDS AND RETAIL INVESTORS IN THE MONEY MARKETS

Because of the wholesale nature of the money markets, retail investors face lower yields on T-bills, BAs, and
commercial paper than those who buy large quantities. The lower yields are a direct result of the cost required to
process money market transactions. For example, if a certain dealer builds in a $20 processing fee for each money
market transaction, the impact on the yield to the client is much larger for a smaller purchase than it is for a larger
purchase.3
Table 8.1 illustrates this fact by showing the yield on a six-month T-bill when a fixed $20 processing fee is added to
the price for various purchase amounts. Without any processing fee, the T-bill’s yield is 2.47%.4

Table 8.1 | Effect of Processing Fee on T-Bill Yields

Face Value Purchased Yield Including $20 Processing Fee

$10,000 2.051%
$25,000 2.302%
$50,000 2.386%
$100,000 2.428%
$250,000 2.453%
$500,000 2.462%
$1,000,000 2.466%

3
Any commission charged by the advisor will reduce the yield further. The impact of commissions is examined later in this chapter as it
pertains to the impact on bond yields.
4
Based on a yield of 2.47%, the price of the 178-day T-bill per $100 of face value is 98.80979. To determine the yields given in the table,
multiply the face value by 98.80979, divide by 100, add $20 to determine the new cost that includes the processing fee, and then determine
the yield based on the new cost. The formulas used to determine price and yield are provided in Chapter 9.

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For larger investment amounts, therefore, money market instruments offer competitive yields, making them a
popular choice as short-term investments for higher net-worth individual investors.

BOND MARKET INSTRUMENTS

BONDS AND DEBENTURES
Bonds and debentures are debt securities issued with a term to maturity greater than one year. Market convention
refers to both bonds and debentures by the generic term bonds. These securities represent a contractual promise
to repay a principal amount on a specified future date (the maturity date), as well as a predetermined method of
paying interest (coupon payments).
Technically, a bond is secured by physical assets in a trust deed written into the bond contract. If the bond goes into
default, the indenture provisions allow the bondholders to seize specified physical assets and sell them to recover
their investment. These physical assets could be a building, a railway car, or any other physical property.
Debentures technically are not secured by a physical asset. Rather, they are guaranteed by a legal contract and
have a claim on the residual assets of the issuer only in the case of bankruptcy. Although government issues are
in practice referred to as bonds, they are not secured by physical assets and therefore are technically debentures.
At various times, market participants may refer to a bond as a debenture or a debenture as a bond. While this has
become common practice in the industry, it is important to understand the distinction between the two. For the
remainder of this chapter, we will use the term bond to refer to both bonds and debentures.
Bonds are generally divided into different categories based on issuer type, credit quality, maturity, and security.

STRIP COUPONS AND RESIDUALS

The cash flow of a fixed-rate bond consists of regular interest payments (coupons) that take place over the term of
the bond and the final principal repayment. In the past, bonds were issued in bearer form and included a detachable
coupon portion that was clipped and submitted for the cash payment when it came due. The final principal amount,
known as the residual, was submitted in the same fashion.
Since the residual and each coupon represent an obligation of the issuer, it is possible to detach each portion of
the physical bond – a practice known as stripping the coupons from the residual – and sell them individually. Under
the book-based system, stripping is performed by depositing bonds with a trustee that then separates the bond
into its individual components, which are traded as individual securities. When the trustee receives the interest
and principal repayments on the original coupon bond, it directs the funds to the individual holders of the stripped
coupons and residual.

EXAMPLE
An investment dealer might buy $10 million face value of a five-year, semi-annual pay Government of Canada
bond with a coupon of 5.50%, intending to strip the bond for sale to clients. With this bond, the dealer can create
10 different strip coupons, each with a face value of $275,000 ($10 million × 0.055 × 1/2). The face value of
each strip coupon is equal to the dollar value of each interest payment on the regular bond. The bond’s principal
repayment can be sold as a residual with a face value of $10 million.

Under the book-based system, coupons and residuals can be traded in minimum increments of $1 beyond the
minimum initial investment. The original fixed-rate bond’s interest payments are known as coupons after their
source of cash flow, and the final payment at maturity is known as the residual, since it is what is left over after the
coupons are stripped off.

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Coupons and residuals are purchased at a discount and mature at their face value, with the difference representing
the return to the investor. Because coupons and residuals pay no cash until maturity, they normally offer higher
yields than bonds of similar term and credit quality and have the added benefit of eliminating reinvestment risk.
Under Canadian tax rules, the return on a coupon or residual is treated as regular interest income, not as a capital
gain.5 Although no interest is paid until maturity, the individual investor must include the notional interest that
accrues each year up to the anniversary date of the issuance of the bond as income unless the coupon or residual is
held in a tax-deferred account or tax-exempt account.
This method of taxation makes coupons a popular choice for tax-deferred accounts or tax-exempt accounts.
Shorter-term coupons are also an attractive alternative to money market instruments for smaller investments,
benefiting from minimum increments of $1 beyond the minimum initial investment.

SPECIAL STRUCTURES
REAL RETURN BONDS
Real return bonds (RRBs) are indexed to inflation. Various governments, including those of Canada, the United
States, and the United Kingdom, have experimented with linking bond returns to an inflation index. Within Canada,
the province of Quebec has also issued RRBs.
An RRB resembles a conventional bond because it pays interest throughout the life of the bond and repays the
original principal amount on maturity. Unlike conventional bonds, however, the coupon payments and principal
repayment are adjusted for inflation.
RRBs have a fixed real coupon rate.6 At each interest payment date, the real coupon rate is applied to a principal
balance that has been adjusted for the cumulative level of inflation since the date the bond was issued. For
RRBs issued by the Government of Canada, the cumulative level of inflation is known as the bond’s inflation
compensation. On each interest payment date, investors receive a coupon payment equal to the real coupon rate
multiplied by the sum of the original principal and the inflation compensation. At maturity, investors are repaid
their original principal plus the inflation compensation. The inflation compensation for Government of Canada RRBs
is based on the Consumer Price Index (CPI), which is published monthly by Statistics Canada.
The calculation for the actual (nominal) semi-annual coupon payment on a Government of Canada RRB is provided
in Equation 8.1.
Real Coupon Rate (8.1)
Payment  q (Principal Inflation Compensation)
2

The inflation compensation is calculated as follows:

 Current CPI ­¬ (8.2)
Inflation Compensation  žžPrincipal q ­  Principal
žŸ Base CPI ­®

5
If the strip coupon or residual is sold before maturity at a yield different from that at which it was purchased, an investor may be able to claim
a capital gain or loss.
6
The fixed real coupon rate is the specified coupon rate for the real return bond.

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For example, the first coupon payment on a newly issued RRB with a 4% real coupon rate would be calculated in
the following way. If the CPI has risen from 100 to 103 over the first six-month period, the first coupon payment will
be $2.06 for each $100 of principal.
 103 ¬­
Inflation Compensation  žž100 q ­  100
žŸ 100 ®­
 103  100

 3

0.04
Payment  q 100 3
2
 0.02 q 103

 2.06

At maturity, in addition to the final coupon payment, holders receive a final principal payment equal to the sum of
the original principal amount plus the inflation compensation accrued from the original issue date.
 ¬
Final Payment  Principal žž ¡Principal q Maturity CPI ¯°  Principal­­ (8.3)
žŸ ¢
ž¡ Base CPI ± ° ­­®

For example, if inflation averaged 2.5% over the life of a 30-year RRB and the CPI index rose from 120 to 251.71, the
final principal payment for this bond would be $209.76 per $100 of face value, calculated as follows:

 ¬
Final Payment  100 žž ¡ 100 q 251.71 °¯  100­­
žŸ ¢
ž¡ 120 °± ­­
®

 100 <100 q 2.0976>  100

 100 109.76

 209.76

When the Government of Canada first issued RRBs, it had to deal with two issues regarding the use of the CPI in the
inflation compensation calculation.
• There is only a single CPI reading for any given month; Statistics Canada does not provide a CPI reading for
each day of the month. This raises two questions: “To which day of the month does the Statistics Canada CPI
reading apply?” and “How does one calculate the CPI reading on any other day of the month?” The answers
are important because RRBs trade in the secondary market and trades can occur on any day. Buyers in the
secondary market must compensate sellers for the accrued inflation compensation. Therefore, there has to be
a way to calculate the inflation compensation on any day, not just one day a month. The answer to the first
question is that for Government of Canada RRBs, the CPI reading for any given month is assumed to be the CPI
on the first calendar day of the month. The answer to the second question is that the CPI reading on any other
day of the month is calculated by linear interpolation between the CPI from the current month and the CPI
reading for the following month. The linear interpolation method assumes an even change in the CPI reading
from one month to the next.

• CPI is a lagging indicator. The CPI reading for any given month is not released until the third week of the
following month. This means that the “current” CPI used in the inflation compensation calculation, by necessity,
refers to a previously announced CPI reading. In fact, the current CPI for Government of Canada RRBs is based
on the CPI reading from the third preceding calendar month. For example, if an investor buys a Government of

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Canada RRB for settlement on June 1, the current CPI used to calculate the inflation compensation payable to
the seller is the CPI reading from March (three months before June). When RRB trades settle on any day other
than the first of the month, the current CPI reading is calculated by linear interpolation between the CPI reading
from the third previous month and the CPI reading from the second preceding month.

Equation 8.4 shows how linear interpolation is used to calculate the value of reference CPI on any date.
t1 ¯ (8.4)
Current CPIDate  CPIM ¡ q CPIM 1  CPIM °
¡¢ D °±

Where:
CPIM = the CPI reading for the third calendar month preceding the month in which the date falls
t = the calendar day corresponding to the date
D = the number of days in the calendar month in which the date falls

For example, an investor buys an RRB for $105 per $100 of face value for settlement on December 20. The
investor must not only pay $105 for each $100 of face value, but must also compensate the seller for the inflation
compensation as of the settlement date. To calculate the inflation compensation as of December 20, the current
CPI in Equation 8.2 is based on the CPI reading for September 20. The exact value of the CPI on this date is based on
linear interpolation between the CPI reading for September and October. (Remember, the inflation compensation is
calculated using linear interpolation between the CPI reading from the second and third preceding months, in this
case, September and October.)
If the CPI for September was 115 and the CPI for October was 116, the current CPI on December 20 is calculated
as follows:

19 ¯
Current CPIDecember 20  CPISeptember ¡ q CPIOctober  CPISeptember °
¡¢ 31 °±

19 ¯
 115 ¡ q 116  115 °
¡¢ 31 °±

 115.613

Thus, when calculating the inflation compensation for this bond, 115.613 is used as the value of the current CPI.
If the value of the base CPI for this bond is 110, then the buyer must pay $110.36 (105 u [115.613/110]) per $100 of
face value plus accrued interest.
The Department of Finance calls the ratio of the current CPI to the base CPI the index ratio. The index ratio for each
calendar day of the month is published on the Bank of Canada’s website.
In an inflationary environment, the inflation compensation rises over time, resulting in increasing nominal coupon
payments and a rising final payment on maturity. Over time, this inflation compensation can become quite
substantial. In a deflationary environment, on the other hand, inflation compensation falls, resulting in a reduction
in both the nominal coupon payments and the final principal amount. Although deflation does not normally occur
over very long periods, there is a chance that an RRB will return less than the face value at maturity if this were to
occur.7

7
Unlike Government of Canada RRBs, real-return bonds issued by the U.S. Treasury, officially known as Treasury Inflation Indexed Securities
(but more commonly referred to as Treasury Inflation Protected Securities, or TIPS), return the greater of par or par plus the inflation
compensation. In other words, if the inflation compensation at maturity is negative as a result of deflation, TIPS holders are guaranteed to
receive par rather than some lower value.

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RRBs have risen in popularity since they were first issued, as understanding of the structure has become more
widespread and the net benefit of government-guaranteed inflation protection is better recognized as a valuable
component in portfolio construction.

MORTGAGE-BACKED SECURITIES
Mortgage-backed securities (MBSs) are investments that represent ownership of the cash flow from a group
of mortgages. In Canada, these mortgages are either residential mortgages insured by the Canada Mortgage
and Housing Corporation (CMHC), in which case they are referred to as NHA (National Housing Act) MBSs, or
commercial mortgages secured by loans with a first lien (a first claim on the property) and over-collateralization
(there are more assets in the pool than the amount of debt issued against the pool).
Most MBSs are issued with terms of three or five years; however, some pools are issued with terms of ten years
or longer. The size of the issues, the large number of issues, and the variety of terms and coupons outstanding in
Canada ensure an active secondary market.
Each MBS is backed by a distinct group of mortgages, known as a pool. The cash flow from each mortgage is
collected and redirected to the investors in the MBS. The creation of this pass-through security effectively converts
illiquid, individual mortgages into liquid securities.
Investors in an MBS receive monthly payments based on an amortization schedule, comprising the monthly cash
flow of the underlying mortgages minus servicing and guarantee fees (fees are charged for collecting the monthly
cash payments from the mortgagees and for payments to other guarantors such as custodians or trustees). Each
monthly payment consists of a blend of the principal being repaid and interest payments based on the pool’s
coupon rate and the remaining principal balance. Only the interest portion of the payment is taxed in Canada as
income. At maturity, any principal that has not been repaid over the life of the pool is returned to the investor. For
NHA MBSs, timely payment to the investor of principal and interest is guaranteed by CMHC.
Although the issue and maturity dates fall on the first of the month, the monthly payments on an MBS are paid on
the 15th day of the month, or the closest corresponding business day. This represents the delay between the time the
mortgage payments are received by the pool, the calculation of the new outstanding mortgage balances, and the
time to deliver the payments to the MBS investors.
To keep track of the remaining principal of an MBS, the trustee produces a number known as the pool factor. The
pool factor represents the percentage of original principal remaining in the mortgage pool after the current month’s
payments.

EXAMPLE
An MBS carrying a coupon of 6% issued two years ago may be offered at a price of $102 per $100 face value.
If the pool factor for this issue is 0.95623, the actual cost of the MBS (before accrued interest) would be $97.535
(102.00 × 0.95623) per $100 of face value.

There are four different types of NHA MBS pools available to investors: exclusive homeowner, multi-family, social
housing (such as co-ops and seniors’ residences), and mixed (a combination of any of the above).
NHA MBSs are identified by an eight-digit number; the first three digits indicate the pool category (homeowner,
multi-family, etc.) and the pool type, open or closed:
• With an open NHA MBS, the mortgages in the pool contain clauses that permit the mortgagors (borrowers)
to make principal prepayments in addition to the regularly scheduled principal and interest payments. An open
MBS therefore carries some uncertainty, as early principal prepayments would alter the monthly cash flow
stream.
• With a closed NHA MBS, the mortgages in the pool do not permit the mortgagors to make principal
prepayments. Therefore, with no unscheduled principal payments, the monthly payment from a closed NHA
MBS is predictable and consistent.

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COMMERCIAL MORTGAGE-BACKED SECURITIES

Mortgage-backed securities based on pools of commercial mortgages are known as commercial mortgage-backed
securities (CMBSs) and are identified by the name of the issuer. The underlying mortgages typically consist of
several properties across Canada, with full disclosure available in the prospectus for each issue. Loans with a first lien
on the commercial real estate property provide security for a CMBS.
In a CMBS structure, the mortgage pool is divided up into tranches and each tranche has a differing claim on the
cash flow of the underlying pool. For example, most CMBS tranches are arranged in different maturity classes. In
a typical CMBS structure, every tranche of the CMBS receives interest payments, while only the first pool receives
principal prepayments, if any. Once the first tranche’s principal is paid off, the second tranche begins to receive
principal prepayments. This occurs sequentially until the principal has been repaid for all tranches.

ISSUER EXTENDIBLE NOTES

Issuer extendible notes are debt instruments for which the issuer has the right at certain points (normally the
anniversary date of issue) either to allow the bond to mature or to extend the maturity. Essentially, issuer extendible
notes are bonds with several embedded issuer call options. Because of the embedded options, most issuer
extendible notes provide higher yields relative to bonds of similar term and credit quality.
Each note is structured in a unique fashion. Most carry coupons that increase should the maturity be extended;
therefore, they are commonly referred to as step-ups.

CAPITAL SECURITIES
Capital securities are subordinated debentures that rank below all other indebtedness of the issuer but above that
of all equity stakeholders. Capital securities often contain other provisions, such as:
• Call features
• Interest deferral features (whereby the issuer has the right to defer paying interest with no penalty)
• Optional redemption rights
• Repayment features (such as paying in shares instead of cash)

There are two common capital securities structures in Canada: capital trust securities and preferred securities.
Capital trust securities resemble bond issues: they have $1,000 par values and are traded in the bond market.
Preferred securities resemble preferred shares: they have $25 par values and trade on a stock exchange.
In the bond market, capital trust securities have been issued by banks and insurance companies. These issues are
normally callable after 10 years. If they are not called, the investor has the right to “put” the security back to the
issuer, most often receiving preferred shares of the issuer in return. These preferred shares typically carry a dividend
equal to the original coupon interest rate and are also convertible into common shares at a discount to current
market pricing. Given that such a redemption would be highly costly to the issuer, these issues trade in the market
with a price based on their call date.
Preferred securities have been issued by industrial and resource companies and utilities. They resemble a preferred
share with a $25 par value and quarterly interest payments, but pay interest rather than dividend income. Most
have very long maturity dates (usually 49 years), and many have call features. In addition, with preferred securities,
accrued interest is built into the purchase or sale price, whereas with capital trust securities, accrued interest is
treated in the same manner as it is for bonds.
Preferred securities and capital trust securities rank above preferred shares in a corporation’s capital structure.

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WHAT ARE THE RISK FACTORS OF DEBT SECURITIES?

Debt securities are generally considered relatively safe investments compared to equities, real estate, or other
assets. As with any investment, however, there are risk factors to consider.

CREDIT RISK OR DEFAULT RISK

The owners of debt securities are primarily concerned with the issuer’s ability to make timely payments of interest
and principal. If timely payment is not made, the issuer is said to be in default. The risk that an issuer may default
on interest and/or principal payments is often referred to as credit risk but is more accurately termed default risk.8
Although the owner of a debt security has certain rights as a creditor of the issuer, the debt security does not
represent ownership rights over the issuer. Rather, creditors receive a higher-ranking claim on the borrower’s income
(and, in the case of bankruptcy, assets) than do owners or shareholders.
Although the ranking of the debt security and the trust indenture represent important legal obligations of the issuer,
they do not measure the ability of borrowers to meet their obligations in a timely manner. Evaluating an issuer’s
ability to meet timely payments is known as credit analysis.

CREDIT ANALYSIS
The purpose of credit analysis is to evaluate an issuer’s ability to service and repay its debt. Credit analysis
comprises:
• Determining the issuer’s existing obligations and the assets that are available as protection for debt holders in
the event of a default;
• Analyzing liquidity and borrowing needs;
• Analyzing cash flow needs.

This process is applied to both corporate and government borrowers. For governments, this analysis involves an
evaluation of the following factors:
• Economic structure
• Growth prospects
• Fiscal policy and budget flexibility
• Monetary policy and price stability
• Public debt burden
• External debt levels and liquidity
• Political risk

For a corporation, this process involves adjusting the firm’s financial statements to reflect current market value,
including measuring the book value of assets and liabilities, adjusting the value of receivables for credit and interest
rate risk. Cash flow must also be adjusted and the trend in cash flow noted.
Traditional credit analysis involved calculating a borrower’s financial ratios using historical data and comparing
them to the average ratios of similar borrowers. However, this process fails to provide a sense of where the borrower
is headed in the future, and therefore does not anticipate future changes in credit quality. Lenders and investors

8
More precisely, default risk is one type of credit risk. Credit risk also includes credit downgrade risk and credit spread risk. Credit downgrade
risk is the risk that the issuer’s credit rating will be downgraded by one or more credit rating agencies, which would, all else being equal, cause
the market value of the issuer’s debt securities to fall. Credit spread risk is the risk that the spread on a debt security relative to a benchmark
yield will increase, which would, all else being equal, cause the market value of the security to fall. Credit spreads are discussed in greater
detail in Chapter 9.

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alike want to anticipate changes in credit quality so they can assess the future ability of the borrower to make
timely payments on its debt securities. Therefore, credit analysis today is similar to equity analysis and is based on
financial forecasting.
Credit analysis is performed by all lenders, from individual investors to banking concerns. In the public debt markets,
credit rating agencies also offer opinions on the general credit quality of an issuer.

CREDIT RATINGS
In Canada, DBRS, Moody’s Canada Inc., and Standard & Poor’s Ratings Services provide independent rating services
for many debt securities.
Rating agencies offer their opinion in the form of a credit rating. A credit rating is not a recommendation to buy,
sell, or hold an investment; rather it represents the rating agency’s opinion of the general creditworthiness of an
issuer with respect to a debt security or other financial obligation based on relevant risk factors.
A rating agency’s ratings scale provides a framework for classifying creditworthiness or the ability of a borrower to
meet its obligations in a timely manner.
Rating agencies review and update their ratings on a regular basis and conduct reviews after major financial
developments. To further assist investors, rating agencies also provide an outlook on the issuer’s financial status or
place the issuer on a credit watch list, with positive, neutral/developing, or negative implications. When an issuer is
placed on a watch list, the rating agency performs a review and releases the conclusions: upgrade, downgrade, or no
change.
The market and regulatory bodies distinguish among the rating agencies’ classifications. Securities carrying a rating
of BBB (low) (or BBB – from S&P, or Baa3 from Moody’s) and higher are considered investment grade. Ratings
below this level are considered non-investment grade, or speculative, and are often referred to as high-yield or
junk bonds.
Market participants use credit ratings as an important consideration in determining the additional yield these debt
securities provide over government issues (the spread). Credit risk, however, is not the only consideration for a debt
investor; many other risk factors are involved with debt securities.

ADDITIONAL RISK FACTORS

MARKET OR INTEREST RATE RISK
The price of a debt security moves in the opposite direction to a change in interest rates: as rates rise, the price of
the debt security falls; conversely, as rates fall, prices rise. When a debt security is held until maturity this is not a
concern, but for investors that plan to sell the instrument before maturity, this is a risk factor to consider.
The amount of change in the price of a debt security as a result of a change in interest rates is related both to the
term to maturity and to the coupon rate, which are factors that are measured by a calculation of the security’s
duration (see Chapter 10). In general, the longer the term to maturity and the lower the coupon rate, the higher the
interest rate risk; conversely, the shorter the term to maturity and the higher the coupon rate, the lower the interest
rate risk.

REINVESTMENT RISK
The yield to maturity quoted on a debt instrument assumes that the coupon interest received can be reinvested at
a rate of return equal to the yield to maturity. However, interest rates fluctuate and therefore this may not be the
case. Reinvestment risk is the risk that an investor cannot invest the coupon income at the bond’s yield to maturity
and will be forced to accept a lower yield and hence a lower rate of return than originally anticipated.

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TIMING OR CALL RISK

Many bonds contain embedded options, including call options that allow the issuer to call the debt instrument
prior to maturity or prepayment options that allow the borrower to pay down a portion of the principal amount
of the loan before maturity. These options represent a disadvantage to the investor because the cash flow of the
investment is not certain. A call will be exercised only when it is an advantage to the issuer (and therefore most
often a disadvantage to the investor), and any opportunity for capital gains due to falling interest rates will be
capped by the call features. To compensate for these disadvantages, callable bonds normally carry a higher yield.

YIELD CURVE AND MATURITY RISK

Investors face the choice of many different debt instruments, with varying maturity dates. The choice of term
is often determined by their specific investment needs, including their perception of which maturity offers the
best rate of return. Yield curve risk refers to the risk that changes in the shape of the yield curve will cause debt
instruments with different maturity dates to change in value at different rates than originally expected.

INFLATION AND PURCHASING POWER RISK

Inflation risk arises because of changes in the purchasing power of a currency over time. Inflation is a serious
concern for investors in debt securities with fixed coupon rates. Although the actual nominal dollar amount of
interest and principal payments is known in advance, if the rate of interest is ultimately less than the rate of
inflation, then the purchasing power of the investment declines.

MARKETABILITY OR LIQUIDITY RISK

Marketability risk concerns the ease with which a debt security can be sold prior to maturity at or near its true value.
The difference between the bid and the offer price of a marketable debt instrument indicates the liquidity of an
issue.

EXCHANGE RATE OR CURRENCY RISK

For an investor purchasing debt securities in a foreign currency, there is the risk that the value of the currency at
each interest payment date and on maturity will not equal that at the time of the original investment. The expected
change in foreign exchange rates is an important component of evaluating foreign currency investments. Generally,
future exchange rates take into account differences in interest rates and expected inflation.

VOLATILITY RISK
For debt instruments with embedded options, the volatility of interest rates, or the volatility of the underlying
security for which the debt security can be exchanged or to which it can be converted, affects the value of the
embedded option and therefore the value of the debt security. For example, as interest rate volatility rises, the value
of a bond’s call option rises, which is negative for callable bond investors.

POLITICAL AND LEGAL RISK

Changes in the legal landscape governing taxes and allowable investments can affect debt securities. For example, a
government could apply withholding taxes on interest payments to foreign investors, declare tax-exempt bonds no
longer tax-exempt, or prevent pension funds from holding certain classes of securities. Each of these actions would
likely lower the market price of the affected securities.

EVENT RISK
Natural disasters, industrial accidents, corporate takeovers, or lawsuits can all impair a borrower’s ability to meet its
financial obligations.

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SECTOR RISK
Debt securities in different sectors of the market respond differently to economic, financial, environmental, or
interest rate changes relative to other sectors because of any of the above risks.

WHAT ARE THE TRADING MECHANICS OF THE DEBT MARKET?

OVER-THE-COUNTER DEALING METHODS

The market for debt securities brings together issuers and investors. Investment dealers communicate with both
parties to assess borrowing needs and lending appetite and to bring deals to the primary market, which is where
the original pricing and sale of a debt security occurs. After a debt security has been issued and distributed, the
secondary market facilitates its purchase and sale for general investment purposes and for managing risk exposure.
Canada, like most other developed nations, has no centralized exchange or facility for bond and money-market
trading. Transactions occur in an over-the-counter market, and investment dealers and other market participants
interact through direct negotiations, using computer networks or by phone.
In the secondary market, investment dealers quote a bid (the price at which they are prepared to buy) and an offer
(the price at which they are prepared to sell). The process of interaction between investment dealers and other
participants either directly or through interdealer bond brokers determines overall market pricing.
Investment dealers primarily earn their profits from the bid/offer spread, which represents compensation for the
significant amount of capital tied up and put at risk in the debt market. Investment dealers also profit from the
fees generated by bringing new issues to market and by using the firm’s capital to make bets on the direction of the
market. In the course of these activities, investment dealers help generate market liquidity.
The spread between bid and offer prices indicates the liquidity of the underlying security, taking into account
expectations about future price movement, the competition between participants, and the cost to investment
dealers of carrying inventory. Smaller spreads represent the ability to move positions in the security more easily.
The liquidity of bonds and T-bills depends on whether they are on-the-run or off-the-run. On-the-run instruments
are known as benchmarks and are the more liquid issues; off-the-run issues are not traded as frequently as the
benchmarks and are therefore less liquid. Liquidity is an important factor in the decision to participate in a market
because it determines the ability to buy and sell positions quickly and with little impact on price. Liquidity in the
benchmark Government of Canada bond market is very high.
Liquidity is a function of both the outstanding size of the issue and the volume traded. According to the Investment
Industry Association of Canada (IIAC), the volume of Government of Canada bond trading was over $7.8 trillion
in 2016, while the value of Government of Canada T-bills traded was over $1.3 trillion in the same period.9
Benchmark issues determine overall interest rates and the shape of the yield curve, since all bonds in the market
are priced in relation to the benchmarks on a yield spread basis (see Chapter 9 for more on the yield curve and yield
spreads). Because of this feature, benchmark issues are often used for hedging – investment dealers typically carry
short positions in benchmark Canada bonds as hedges against their long positions in other debt securities to protect
themselves from market risk.
Most debt securities issued in Canada are government obligations. Based on the FTSE TMX Canada Universe Bond
Index, as of August 2017, approximately 70% of the total market value of $1.54 trillion represented government and
government-guaranteed issues while the corporate sector represented the remaining 30%.

9
Source: IIAC Bond Market Secondary Trading Annual and IIAC Money Market Secondary Trading Annual.

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The bulk of bond and money market trading in Canada is carried out between investment dealers and institutional
clients, such as pension funds, insurance companies, large corporations, and mutual funds. The size of the assets
managed by these investors requires their active presence in the markets. Given the amount of business they
conduct, a client relationship is highly sought after and well serviced by investment dealers.
The interaction between this relatively small group of sophisticated and experienced investors ensures considerable
efficiency in Canadian debt markets. Because of the competition between investment dealers, ascertaining the true
value or price (known as price discovery) of larger, more liquid issues is relatively easy, and pricing and placement
of new issues in the primary market is effective and well organized.
For smaller, less liquid securities, price discovery can be more difficult. The over-the-counter nature of the debt
market means that investment dealers must act as the counterparty to every client transaction. The willingness of
an investment dealer to take on positions in securities they cannot sell easily is limited. An issuing dealer may make
markets in such securities, but they have no obligation to do so. With no open market to offer such securities, the
investment dealer must work harder on behalf of its clients to find buyers.
Individual investors depend on investment dealers both for access to product and for the ability to transact business
in debt markets. Although collectively individual investors represent a significant proportion of trading activity, the
smaller size of each transaction means that individuals are price takers, meaning they have a very limited ability to
negotiate prices, and the bid/offer spread can be wider because of the higher administrative costs associated with
individual investors. Furthermore, the transparency of market pricing for individual investors is limited because
there is no single public display.10 It is, however, in the best interests of investment dealers to assume collective
responsibility for maintaining liquidity and orderly markets. Furthermore, because of competition between
investment dealers, individual investors can be assured of pricing that reflects the broader market.

TRADING FOR INDIVIDUAL INVESTORS THROUGH INVESTMENT

ADVISORS
The bond-trading approach of investment advisors acting on behalf of their clients varies according to the bond-
trading capacity of their firm.

TRADING IN FIRMS WITH A LARGE INSTITUTIONAL DEALING DESK

In firms with a large institutional dealing desk, investment advisors are typically serviced by a retail trading desk. The
role of the retail desk is in many ways similar to that of the institutional sales desk. Its primary function is to service
the investment advisors by sourcing products and providing market commentary.
The advantage of dealing within a larger firm is access to the wide range of securities in its inventory. Typically, each
firm has a proprietary trading system linked directly to its inventory, which allows for automatic execution of trades.
Most trades take place using the system, with no need to contact the retail trading desk by phone. For large trades,
however, auto-execution is not normally available, and trades must be confirmed over the phone. This requirement
ensures that traders are aware of large flows into and out of their inventory and allows them to ensure accurate
pricing based on current markets. The retail trading desk will also source products not offered on the trading system,
either by negotiating with the institutional trading desk or by turning to other dealers.
Retail trading desks normally operate under one of two different methods. Certain firms operate this desk as a cost
centre, meaning the retail trading desk is not set up to make profits in the market and the cost of maintaining a
presence on the institutional trading floor is covered by the investment advisors’ commissions and fees withheld by
the firm. Other firms operate this desk as a profit centre, meaning the retail desk buys inventory and offers it out,
attempting to profit on these trades to cover operating costs.

10
Unlike most equity markets, there is no way for an individual investor to find information such as the current bid and ask price, last trade
price, depth of market, or volume transacted in the debt securities market. The most an individual investor can find out is the price at which
an investment dealer is willing to buy or sell a particular debt security, usually by asking an investment advisor.

© CANADIAN SECURITIES INSTITUTE (2017)

 CHAPTER 8 | DEBT SECURITIES 8 • 21

The retail trading desk may provide additional services, including recommending trades, providing supplementary
credit research, and advising on reorganizations, as well as portfolio construction and management advice.

TRADING IN FIRMS WITHOUT A LARGE INSTITUTIONAL DEALING DESK

In firms without a large institutional dealing desk, investment advisors are served by a trading desk as the source
of product. Without a large inventory to draw on, this desk must build its own inventory of product and source
products it does not own from other dealers.
The lack of an inventory at these firms reduces the investment advisor’s ability to become familiar with a wide
range of offerings and to know what product is readily available. Therefore, it is the responsibility of the trading desk
to provide this information. Because there is no large institutional dealing desk, the trading desk must search for
competitive offerings from more than one dealer. Often, larger firms in this situation receive institutional coverage
from the major dealers, as they frequently carry out large trades. The traders at the firm without the institutional
dealing desk need to forge relationships with sales staff at the major dealers, who in turn supply them with market
commentary, market levels, and often limited inventory offering sheets as well.
As with dealers that have a large institutional dealing desk, the trading desk can operate as either a cost centre or as
a separate profit centre.

FEE STRUCTURES
In addition to the bid/offer spread, individual investors face other charges that reflect the additional administrative
costs of trades in individual client portfolios.
Fee-based programs charge clients based on the value of assets held in an account at a firm. In a fee-based program,
administrative and service costs are typically charged four times a year. In return, investors are given the same price
as that given to the investment advisor by the trading desk.
Commission-based accounts charge clients for each trade. The commission taken by the investment advisor is built
into the price of the debt security, thereby increasing offer prices and reducing bid prices. As a result, the bid/offer
spread after commission for an individual investor can be more than $2 for each $100 of face value.11
Because of the price-yield relationship of debt securities, the commission charged on a bond trade directly affects
the yield. This effect is related to the size of the commission and to the maturity of the debt security. Generally, the
longer the maturity, the less impact the same price change will have on the yield.

EXAMPLE
Impact on Yield of Same Commission for Different Maturities
Consider two bond issues: a 5% annual-pay two-year bond offered at par, and a 6% annual-pay ten-year bond,
also offered at par. What will happen to the yield on these two issues if the investment advisor charges $0.50
commission for each $100 of face value?
Using a financial calculator, we find that the yield on a 5% annual-pay two-year bond offered at $100.50
is 4.73%, or 27 basis points below the offer yield before commissions. For the 6% annual-pay ten-year bond,
a price of $100.50 translates into a yield of 5.93%, or 7 basis points below the offer yield before commissions.

11
When a client buys a debt security in a commission-based account, the investment advisor adds his or her commission to the price at which
the trading desk is willing to sell the bond. In effect, the investment advisor buys the debt security from the trading desk and sells it to the
client at a higher price. When a client sells a debt security, the investment advisor deducts his or her commission from the price at which the
trading desk is willing to buy the bond. In effect, the investment advisor buys the debt security from the client and sells it to the trading desk
at a higher price.

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8 • 22 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

Commissions are negotiated between the investment advisor and the client, but because institutional pricing is
published in the financial press and individual investors make comparisons with these prices, commissions typically
average no more than 15 basis points in yield, or roughly $0.10 per $100.00 face value, for each year to maturity.
Table 8.4 shows the impact on yield of charging $0.10 per $100 of face value per year of term to maturity. All bonds
in the table are semi-annual bonds with a 5% coupon and are trading at par.

Table 8.4 | Impact of Commissions on Yield

Term Typical Commission Estimated Effect on Yield

1-year $0.10 10.4 bps
2-year $0.20 10.6 bps
3-year $0.30 10.9 bps
4-year $0.40 11.1 bps
5-year $0.50 11.4 bps
6-year $0.60 11.7 bps
7-year $0.70 11.2 bps
8-year $0.80 12.3 bps
9-year $0.90 12.5 bps
10-year $1.00 12.8 bps
30-year $1.50 9.7 bps

© CANADIAN SECURITIES INSTITUTE (2017)

 CHAPTER 8 | DEBT SECURITIES 8 • 23

SUMMARY
By the end of this chapter, you will be able to:
1. Compare the features of various debt securities.
The principal types of debt securities are money market and bond market securities including debentures.
• Money market securities: issued with maturities of one year or less, Canadian money market securities
commonly appear in three forms: Treasury bills, bankers’ acceptances and commercial paper.
• Bond market securities: are obligations with a term greater than one year. Both bonds and debentures come
from a variety of different issuers with various credit qualities, maturities and levels of security.
« Strip coupons and residuals are created when the coupon payments and principal repayment of a regular
bond are separated and sold individually.
« Real return bonds (RRBs) are indexed to inflation, making them an ideal investment to protect against
inflation or purchasing power risk.
« Mortgage-backed securities (MBS) are investments that represent ownership of the cash flows from a group
of mortgages.
« Commercial Mortgage-Backed Securities (CMBS) are backed by pools of commercial mortgages.
« Issuer Extendible Notes are obligations with embedded call options owned by the issuer that allow the
issuer at certain times (usually the anniversary issue date) to pay off the bond or extend the maturity.
« Capital securities are subordinated debentures that rank below all other indebtedness of the issuer but
above that of all equity stakeholders.

2. List risk factors of various debt securities.

• Credit risk: The risk that an issuer may default on interest and/or principal payments.
• Market or interest rate risk: The price of a debt security moves in the opposite direction to a change in interest
rates: as rates rise, the price of the debt security falls; conversely, as rates fall, prices rise.
• Reinvestment risk: An investor may not receive the return on a bond expected at the time of purchase (the
yield to maturity) because interest rates fluctuate and coupon interest may be reinvested at a rate lower than
the yield to maturity.
• Timing or call risk: A bond may be called or paid off earlier than its term to maturity at a price lower than the
market price of similar term to maturity non-callable bonds.
• Yield curve and maturity risk: changes in the shape of the yield curve can cause debt of differing maturities to
change in value at different rates than expected.
• Inflation or purchasing power risk: if inflation is higher than expected over the term to maturity, the
purchasing power of the bond declines.
• Marketability or liquidity risk: an investor may not be able to sell a debt security prior to maturity at or near
its true value.
• Exchange rate or currency risk: the risk that the value of the currency at each interest payment date and on
maturity will not equal that at the time of the original investment.
• Volatility risk: interest rate volatility, or the volatility of the underlying security for which the debt security can
be exchanged or to which it can be converted, affects the value of the embedded option.
• Political and legal risk: changes in the legal landscape governing taxes and allowable investments can affect
debt securities.

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8 • 24 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

• Event risk: natural disasters, industrial accidents, corporate takeovers or lawsuits can impair an issuer’s ability
to meet its financial obligations.
• Sector risk: Debt securities in different sectors of the market respond differently to economic, financial,
environmental, or interest rate changes relative to other sectors because of any of the above risks.

3. Explain the mechanics of debt trading.

• There is no centralized exchange for the trading of debt securities.
• Pricing of debt in the secondary markets occurs as dealers make bid/ask quotes and interact with each other.
• The costs of trading can have a noticeable effect on the eventual yield the investor receives. Generally, the
longer the maturity, the less an impact a price change will have on yield.

© CANADIAN SECURITIES INSTITUTE (2017)

 Analysis of Debt Securities I:
Valuation, Term Structure, 9
and Pricing

CONTENT AREAS

How Are Debt Securities Valued?

What Is the Term Structure of Interest Rates?

How Are Debt Securities Prices Determined?

LEARNING OBJECTIVES

1 | Calculate the price, accrued interest, or yield of any debt security.

2 | Describe what is represented by various yield curve shapes.

3 | Explain the pricing of bonds against a benchmark yield curve.

© CANADIAN SECURITIES INSTITUTE (2017)

 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9•3

INTRODUCTION
Before they can make recommendations to their clients, investment advisors must understand the potential risks
and rewards of investing in debt securities. An important part of this process is knowing how bond yields and prices
are determined using different conventions in the various sectors of the debt securities market.
This chapter begins with a discussion of the valuation of debt securities, including the price and yield of strip
coupons, fixed-coupon bonds, and money market securities. A review of the term structure of interest rates follows,
and then factors that affect the yield on Government of Canada debt securities are discussed. The chapter concludes
with an introduction to and explanation of the importance and behaviour of yield spreads.

HOW ARE DEBT SECURITIES VALUED?

THE TIME VALUE OF MONEY

The key to understanding how the market values a bond, a T-bill, a mortgage, or any other debt security is the
concept of the time value of money.

EXAMPLE
Suppose you have $100,000 in cash. The present value of your money is $100,000. Now, assume you deposit
this money into a bank account that carries an interest rate of 1% paid annually. How much money will you have
in one year’s time? You will have your original $100,000 plus 1% interest, or $1,000, for a total of $101,000. The
future value of your money is thus $101,000.
If you keep the initial deposit and the first year’s interest in the account for another year and the interest rate
remains at 1%, the value of your money at the end of two years would be $102,010 ($101,000 × 1.01). The
$2,010 of total interest is made up of $1,000 for the first year and $1,010 for the second year. The interest was
$10 greater in the second year because you earned not only 1% on your initial deposit of $100,000, but also 1%
interest on the $1,000 interest from the first year. This is known as compound interest.

Equation 9.1 can be used to calculate the future value of any investment benefiting from compound interest.
FV = PV × (1 + i)n (9.1)

Where:
PV = present value
FV = future value
i = interest rate per period (usually shown as I/Y on a financial calculator)
n = number of compounding periods

To see the benefits of compounding over a longer time frame, suppose the $100,000 deposit and all annual interest
payments are left in the account for five years and the interest rate each year is 1%. What is the future value in this
case?
FV = $100,000 × (1.01)5
= $100,000 × 1.051010
= $105,101.01

Therefore, the future value of your money after five years is $105,101.01.

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9•4 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

This logic can be worked in reverse. The current value can be calculated of an investment that guarantees a certain
amount in the future, thus giving the present value of a known future value.
What would you pay today to invest in a security that offered you a guaranteed sum of $100,000 in five years?
In other words, what is the present value of this investment? If a five-year investment of this type should generate
a compound rate of return of 1% a year, then you can find what you would be willing to pay for it today by using
Equation 9.1 to solve for the present value.
5
$100,000  PV q 1.01

$100,000
PV  5
1.01

$100,000

1.051010
 $95,146.57

Therefore, the present value of this investment is $95,146.57.

The present value of any investment that makes a single payment on a future date is calculated using Equation 9.2.
FV (9.2)
PV  n
1 i

All debt securities are valued (priced) using this concept. That is, the value or price of any debt security is the present
value of its expected cash flow discounted at an appropriate interest rate. The appropriate interest rate for each
debt security is often called its yield or yield to maturity. Equation 9.2 is not adequate, however, for most debt
securities because of variations in the number and timing of expected cash flows, as well as different conventions
used in different segments of the debt securities market.
The remainder of this section shows how to calculate the price of strip coupons and residuals, bonds, and money
market securities.

STRIP COUPONS
It is easy to calculate the price or yield of a strip coupon or residual because there is only one interest or face
value payment made on these debt securities. Either calculation requires only two variables: (a) the price (when
calculating the yield) or the yield (when calculating the price), and (b) the number of days to maturity.
One other factor affects the pricing of strip coupons. Since most bonds in Canada pay interest twice a year, the yield
to maturity on bonds is actually a semi-annual yield.1 To make the yield on strip coupons (and residuals) directly
comparable to the yield on other bonds, strip coupon yields are often quoted with equivalent semi-annual yields as
well as annual yields. Most firms provide both yields to advisors through their order entry system. Some firms put
both yields in the confirmations sent to clients; others include only one. The calculations for the price or yield for
both methods are presented below.

1
Be careful with the terminology. The term “semi-annual yield” can mean two things: it can mean two times the semi-annual yield or the
actual semi-annual yield. The former is an annualized yield, the latter is not. Because it is common practice in the industry to use the first
definition, for the remainder of this section, semi-annual yield will mean two times the semi-annual yield for an annualized yield.

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9•5

STRIP COUPON AND RESIDUAL PRICES

Given the equivalent annual yield and the number of days to maturity, Equation 9.3 is used to calculate the price of
a strip coupon or residual.
100
Price  n
1 yA 365 (9.3)

Where:
yA = the equivalent annual yield
n = the number of days to maturity measured from the settlement date

If the settlement date happens to coincide with the maturity date, the (n/365) expression can be replaced with the
number of years to maturity. Otherwise, the exact number of days is used.
For example, a Province B residual maturing on December 29, 20X4, is offered with an equivalent annual yield of
3.04% for settlement on August 7, 20X2. There are 874 days from settlement to maturity.

100
Price  874
1.0304 365
100

1.03042.39452
100

1.0743425
 93.08

The price of this residual per $100 of face value is $93.08.

Given the equivalent semi-annual yield and the number of days to maturity, Equation 9.4 can be used to calculate
the price of a strip coupon or residual.
100 (9.4)
Price  2q n
1 y SA 2 365

Where:
ySA = the equivalent semi-annual yield

If the settlement date happens to coincide with the maturity date, the (2 × n/365) expression can be replaced with
(2 × the number of years to maturity). Otherwise, the exact number of days is used.
For example, if a Province B residual is offered with an equivalent semi-annual yield of 3.02%, it would be priced
at $93.07.
100
Price  2q874
1 0.0302 2 365

100

1.01514.78904
100

1.074412
 93.07

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9•6 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

STRIP COUPON AND RESIDUAL YIELDS

Given the price and the number of days to maturity, Equation 9.5 can be used to calculate the equivalent annual
yield of a strip coupon or residual.
365
 100 ¬­ n (9.5)
Equivalent Annual Yield  žž 1
žŸ Price ­®­

If the Province B residual is offered at a price of 93.08, its equivalent annual yield is calculated as 3.04%.
365
 100 ¬­ 874
Annual Yield  žž 1
žŸ 93.08 ­®­

 1.07434470.41762  1

 1.0304  1

 0.0304

 3.04%

Given the price and the number of days to maturity, Equation 9.6 can be used to calculate the equivalent semi-
annual yield of a strip coupon or residual.
365
¯ (9.6)
¡ž 100 ¬­ 2qn °
Semi-Annual Yield  ¡ž ­  1°q2
¡žŸ Price ­® °
¢ ±

If the Province B residual is offered at 93.08, its equivalent semi-annual yield is calculated as 3.02%.
365
¯
¡ž 100 ¬­ 2q874 °
Semi-Annual Yield  ¡ž ­
­  1°q2
ž
Ÿ
¡ 93.08 ® °
¢ ±

 1.07434470.20881  1 q 2

 1.01509  1 q 2

 0.01509 q 2

 0.03018

 3.02%

BONDS
CALCULATING BOND PRICES GIVEN THE YIELD TO MATURITY
For bonds with a term to maturity of greater than one year, calculating the price given the yield requires one
present value calculation for each expected payment. This section shows how to determine the price only when the
settlement date falls on a coupon payment date.

EXAMPLE
Consider an annual-pay bond with a 5% coupon and exactly three years until maturity. If the bond is trading with
an annual yield of 5.5%, what would its price be? This bond will pay three coupons of $5 each year and return
the $100 principal at maturity.

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9•7

To find out the price today, calculate the present value of each coupon payment and the final principal repayment
and add them together. Knowing that the last coupon will be paid on the same day the principal is repaid, the price
of this bond is calculated as follows:
5 5 105
Price  1 2 3
1.055 1.055 1.055

5 5 105

1.055 1.113025 1.174241
 4.739 4.492 89.419
 98.65

The assumption of annual coupons in the previous example does not reflect the reality of the Canadian domestic
bond market, however, because most issues pay coupons twice a year. For these bonds, the interest rate used to
discount the stream of cash flow is one-half the semi-annual yield.

EXAMPLE
Consider a bond identical to the one in the previous example that pays semi-annual coupons rather than annual
coupons. If the semi-annual yield is 5.5%, the interest rate used to discount the cash flow is 2.75%. The price of
the bond with semi-annual coupons is:
2.5 2.5 2.5 2.5 2.5 102.5
Price  1 2 3 4 5 6
1.0275 1.0275 1.0275 1.0275 1.0275 1.0275

2.5 2.5 2.5 2.5 2.5 102.5


1.0275 1.05576 1.08479 1.11462 1.14527 1.17677
 2.433 2.368 2.305 2.243 2.183 87.103

 98.635

Given the semi-annual yield, Equation 9.7 can be used to calculate the price of a semi-annual-pay bond with a term
to maturity of one year or more.
Nq2 (9.7)
Couponn Principal
Price  œ1
n 1 y SA 2
n
1 y SA 2
Nq2

Where:
ySA = the semi-annual yield
n = the semi-annual period, measured from today
(e.g., n = 1 is the first semi-annual period, n = 2 is the second semi-annual period, etc.)
N = the number of years to maturity

For bonds with several years to maturity, using Equation 9.7 can be cumbersome because of the number of present-
value calculations required. Equation 9.8 is an approximation to Equation 9.7 and can be used to speed up the
calculation of the bond price given its semi-annual yield.
 ¬­¯ (9.8)
¡ Coupon žž 1 ­­°° Principal
Price  ¡ q ž1  Nq2 ­
¡ y SA 2 žž 1 y SA 2 ­­®°° 1 y SA 2
Nq2
¢¡ Ÿ ±

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9•8 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

The following calculation uses Equation 9.8 to show that the two formulas give approximately the same answer.
 ¬­¯
¡ 2.5 ž 1 ­­°° 100
Price  ¡ q žž1  3q2 ­
¡ 0.055 2 žžŸ 1 0.055 2 ­­°
®±° 1 0.055 2
3q2
¢¡
 ¬­¯
¡ 2.5 ž 1 ­­°° 100
 ¡ q žž1  ­
¡ 0.0275 žŸž 6­
1.0275 ­®°° 1.0275
6
¡¢ ±
 ¡¢90.9091 q 1  0.849785 ¯°± 84.9785

 13.6559 84.9785
 98.634

SHORTCOMINGS OF THE YIELD TO MATURITY

The yield to maturity in Equations 9.7 and 9.8 is an internal rate of return, which is the interest rate that equates
the present value of a series of cash flows to their price. As an internal rate of return, the yield to maturity of a bond
is a measure of the true return only if the following conditions are met:
• The bond is held until maturity;
• All cash flows are received (the issuer does not default) and are re-invested at a rate equal to the yield
to maturity.

If either condition is violated, the actual return on a bond will differ from its yield to maturity.

CALCULATING THE YIELD TO MATURITY OF BONDS GIVEN THEIR PRICE

Given the price of a semi-annual-pay bond (the left hand side of Equations 9.7 and 9.8), the semi-annual yield is the
interest rate that equates the present value of the future cash flows (the right-hand side of the equations) to this
price.
For example, what is the semi-annual yield on a two-year semi-annual-pay bond with a 5% coupon, priced at $99?
In other words, what value of ySA satisfies the following equation?
 ¯
¡ 2.5 ž 1 ­­¬° 100
99  ¡ q žž1  ­
4 ­°
¡ y SA 2 žžŸ 1 y SA 2 ­­®°° 1 y SA 2
4
¡¢ ±

It turns out that there is no way to re-arrange Equation 9.7 or 9.8 to solve for the semi-annual yield. The only way to
determine the yield is by trial and error. In other words, make a guess at the correct yield and plug it into the right-
hand side and see how the price comes out.
If the price based on your first guess is less than 99, then you guessed too high and you should lower the yield value.
If the price is greater than 99, then your guess was too low and should be raised. Eventually, you will hone in on the
correct yield. An alternative to guessing is to use a financial calculator (which uses the same process, but does it
much faster), which calculates an answer of 5.54%.2

2
Using a financial calculator, enter 100 for the FV, –99 for the PV (negative to indicate cash outflow), 4 for N, 2.5 for the PMT, and then solve
for I/Y. The answer is 2.7675. The semi-annual yield is two times this value, or 5.54%.

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9•9

CALCULATING THE YIELD OF BONDS WITH EMBEDDED CALL OR PUT OPTIONS

For callable and putable bonds, market participants calculate not only the yield to maturity, but also the yield to
each potential call or put date. The yield to a potential call or put date is known as the yield to call or yield to put.
Calculating the yield to call or put is similar to calculating the yield to maturity, but only the cash flows until the call
or put date are considered. When there is multiple potential call or put dates, market participants usually calculate
the yield to each potential call date.
For example, a five-year corporate bond with semi-annual coupons is offered at a price of $107.10. The bond has a
coupon rate of 6% and is callable in three years at $102 or in four years at $101. As with non-callable bonds, the
semi-annual yield to maturity of the callable bond is the value for ySA that satisfies the following equation:
3 3 100 3
107.10  2
y 10
1 y SA 2 1 y SA 2 1 y SA 2

Using a financial calculator, we find that the semi-annual yield is 4.40%.

The semi-annual yield to the first call date is the value for ySA that satisfies the following equation, which
incorporates only the cash flows until the third year:

3 3 102 3
107.10  2
y 6
1 y SA 2 1 y SA 2 1 y SA 2

Using a financial calculator, we find that the semi-annual yield to the first call date is 4.09%.
The semi-annual yield to the second call date is the value for ySA that satisfies the following equation, which uses
the cash flows until the fourth year:
3 3 101 3
107.10  2
y 8
1 y SA 2 1 y SA 2 1 y SA 2

Using a financial calculator, we find that the semi-annual yield to the second call date is 4.28%.
For callable bonds, the lowest yield from this set of yields – known as the yield to worst – is taken as the assumed
yield. For the bond described above, the yield to worst is the yield to the first call date, 4.09%. Market participants
often compare the worst yield to option-free bonds of a similar term to determine which bond offers better value.
However, this analysis can be too simple and can lead to inaccurate decisions.
Table 9.1 shows a sample of such a comparison. The callable bond’s yield to each call date and yield to maturity are
compared to Government of Canada yields with a similar maturity and the yields on corporate bonds with a similar
maturity and credit rating.

Table 9.1 | Analyzing Callable Bond Yields

Callable Bond Yield Government of Spread Non-Callable Spread

Year to Call/Maturity Canada Yield (In Basis Points) Bond (In Basis Points)
3 4.09% 3.58% 51 3.72% 37
4 4.28% 3.96% 32 4.10% 18
5 4.40% 4.24% 16 4.43% -3

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Although the yield to the first call date in year three appears to be the worst, this term actually offers an attractive
return considering the spread or yield pick-up over other yields in the market.3 The worst case for this bond is more
accurately in the five-year area, where the spread over option-free bonds of comparable risk becomes negative.
Based on this analysis, an investor looking to invest in a five-year bond would be better off buying the five-year
option-free bond instead of the five-year callable bond.

CALCULATING THE YIELD OF A BOND PORTFOLIO

Market participants sometimes state that the yield or yield to maturity on their bond portfolio is “x%”. The yield
to maturity of a bond portfolio is simply the internal rate of return of all the bond’s expected cash flows and is
sometimes known as the portfolio’s cash flow yield.
For example, suppose an investor buys $500,000 of each of the following two bonds:
• Two-year semi-annual pay bond with a coupon rate of 5% and a price of 100 to yield 5%
• Five-year semi-annual pay bond with a coupon rate of 6% and a price of 100 to yield 6%

For the first two years, the portfolio will receive cash flows from both bonds. For the three years after that, only the
five-year bond will provide the portfolio with cash flows. The cash flow schedule for this portfolio over the next five
years is as follows:

Months from Today Cash Flow from 2-Year Bond Cash Flow from 5-Year Bond Total Cash Flow
6 $12,500 $15,000 $27,500
12 $12,500 $15,000 $27,500
18 $12,500 $15,000 $27,500
24 $512,500 $15,000 $527,500
30 – $15,000 $15,000
36 – $15,000 $15,000
42 – $15,000 $15,000
48 – $15,000 $15,000
54 – $15,000 $15,000
60 – $515,000 $515,000

The semi-annual yield of this portfolio is the value of ySA that satisfies the following equation:

$27,500 $27,500 $27,500 $527,500

$1,000,000  1 2 3 4
1 y SA 2 1 y SA 2 1 y SA 2 1 y SA 2

$15,000 $515,000
5
y 10
1 y SA 2 1 y SA 2

Using a financial calculator, we find that the semi-annual yield is 5.70%.

3
The spread equals the yield on the Government of Canada or non-callable bond, minus the yield on the callable bond. Spreads will be
discussed later in this chapter.

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As an internal rate of return, the yield of a bond portfolio assumes that both bonds are held to maturity and that all
the cash flows are reinvested at the yield to maturity.
Some investors believe that the yield to maturity of a bond portfolio (as defined here) is equal to the weighted
average of the yields on the individual bonds within the portfolio. If this were the case, the yield on the portfolio
above would be 5.50% [(0.5 × 5%) + (0.5 × 6%)]. Since the yield to maturity of the portfolio is actually 5.70%, it
should be clear that the yield to maturity of a bond portfolio is not equal to the weighted average of the individual
bond yields. Chapter 10 introduces the concept of modified duration, which can be used to calculate the yield to
maturity of a bond portfolio more quickly than the cash flow yield calculation.

ACCRUED INTEREST
If a bond is purchased between coupon payment dates, the buyer must compensate the seller for interest that
has accrued since the last coupon payment date but has not yet been paid. This amount, called accrued interest,
depends on the number of days that have passed from the last coupon payment date to the settlement date.
For each debt security, market convention dictates how to calculate the number of days between coupon payment
dates. There are four different day count methods:
• Actual/365
• Actual/Actual
• Actual/360
• 30/360

Table 9.2 lists which day count method is used for which bonds.

Table 9.2 | Day Count Methods

Day Count Method Bonds

Actual/365 • Government of Canada bonds

• Provincial bonds

Actual/Actual • U.S. Treasury notes and bonds

• Canadian corporate bonds

Actual/360 • Eurobonds

30/360 • U.S. agency bonds

• U.S. municipal bonds
• U.S. corporate bonds

ACTUAL/365 DAY COUNT METHOD

For the actual/365 day count method, the actual number of days from the last coupon date is counted, and accrued
interest is calculated by multiplying the annual coupon payment by the actual number of days divided by 365.
Equation 9.9 is used to calculate the accrued interest per $100 of face value using the actual/365 method.
DSLC (9.9)
Accrued Interest Actual /365  Coupon Rate q
365
Where:
DSLC = the number of days since the last coupon payment

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EXAMPLE
A Government of Canada 5.25% bond maturing on December 1, 20X9, was offered at a price of 104.51 for
settlement on December 30, 20X1. The number of accrued days is the actual number of days from the last
coupon payment, which for this bond was December 1, 20X1, to the settlement date.
When counting the actual number of days since the last coupon payment, include the coupon payment date but
do not include the settlement date.* Therefore, the number of days between December 1 and December 30 is 29.
The accrued interest for this bond, per $100 of face value, is $0.4171.
29
Accrued Interest Actual /365  5.25 q
365
 $0.4171

If an investor bought $50,000 face value of this bond, the total cost would be $52,463.55
[($104.51 + $0.4171)/100 × $50,000].

* As long as you remember not to include both the settlement date and the last coupon payment date, it does not matter which you do
not count; just do not count them both.

ACTUAL/ACTUAL DAY COUNT METHOD

For the actual/actual day count method, the actual number of days from the last coupon period is counted, and
accrued interest is calculated by multiplying the actual coupon payment by the actual number of days divided by
the actual number of days in the current coupon period.
Equation 9.10 is used to calculate the accrued interest per $100 of face value using the actual/actual method,
assuming coupons are paid twice a year.
Coupon Rate DSLC (9.10)
Accrued Interest Actual / Actual  q
2 DCP

Where:
DCP = the number of days from the last coupon payment to the next coupon payment

EXAMPLE
The XYZ International Inc. 6.55% bond maturing on October 18, 20X4, was offered at a price of 107.912 for
settlement on December 30, 20X1. The number of accrued days is the actual number of days from the last
coupon payment, which for this bond was October 18, to the settlement date. Including the last coupon payment
date but not the settlement date, the number of days accrued is:

Month Days
October 18 – 31 14
November 1 – 30 30
December 1 – 29 29
Total 73

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9 • 13

EXAMPLE
Cont'd
The total number of days from October 18 until the next coupon payment date, which is April 18, 20X2, is:*

Month Days
October 18 – 31 14
November 1 – 30 30
December 1 – 31 31
January 1 – 31 31
February 1 – 29 29
March 1 – 31 31
April 1 – 17 17
Total 183

The accrued interest for this bond, per $100 of face value, is $1.3064.
6.55 73
Accrued Interest Actual / Actual  q
2 183
 3.275 q 0.3989

 1.3064

If an investor bought $50,000 face value of this bond, the total cost would be
$54,609.20 [($107.912 + $1.3064)/100 × $50,000].

* Just as when counting the days accrued, count either the last coupon payment date or the next, but not both. In this case, October 18,
20X1, was counted but April 18, 20X2, was not.

ACTUAL/360 AND 30/360 DAY COUNT METHODS

For the actual/360 day count method, a year is assumed to have only 360 days, and the actual number of days
since the last coupon is counted for purposes of calculating the accrued interest.
For the 30/360 day count method, a year is assumed to be 360 days and each month is assumed to have 30 days.
When calculating the number of days accrued using this method, no month can count for more than 30 days.

A FINAL NOTE ON CALCULATING ACCRUED INTEREST

In this section, each accrued interest calculation per $100 of face value has been rounded to four decimal places.
The degree of accuracy to which firms will calculate accrued interest may vary, which affects the actual amount of
accrued interest paid by those who buy bonds.

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MONEY MARKET SECURITIES AND BONDS WITH A MATURITY

OF LESS THAN ONE YEAR
CALCULATING MONEY MARKET YIELDS GIVEN THEIR PRICE
Although a money market security is conceptually equivalent to a strip coupon (because there is only one
payment), money market yields are calculated in a slightly different manner than strip coupon yields. In Canada, the
quoted yield on a money market security such as a T-bill, Bankers’ Acceptance (BA), or commercial paper issue is
known as the bond equivalent yield (BEY). Given the price of a Canadian money market security per $100 of face
value, Equation 9.11 is used to calculate the quoted yield.
100  Price 365 (9.11)
BEY  q
Price n

Where:
n = the number of days to maturity

EXAMPLE
The yield quoted on a 92-day Canadian T-bill priced at 99.282 is 2.87%.
100  99.282 365
BEY  q
99.282 92
0.718
 q 3.96739
99.282
 0.007232 q 3.96739

 0.0287

 2.87%

In the United States, money market security yields are quoted using the bank discount rate (BDR) method,
according to Equation 9.12.
100  Price 360 (9.12)
BDR  q
100 n

Where:
n = the number of days to maturity

EXAMPLE
The yield quoted on a 92-day U.S. T-bill priced at 99.282 is 2.81%.
100  99.282 360
BDR  q
100 92
0.718
 q 3.91304
100
 0.00718 q 3.91304

 0.0281

 2.81%

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9 • 15

CALCULATING MONEY MARKET PRICES GIVEN THEIR YIELD

Given the quoted yield on a Canadian money market security, use Equation 9.13 to calculate its price.
100 (9.13)
Price 
 ¬
1 žžBEY q n ­­
žŸ ­
365 ®
Where:
BEY = the quoted yield (bond equivalent yield)

Given the quoted yield on a U.S. money market security (the bank discount rate), use Equation 9.14 to calculate
its price.
 n ¬­
Price  100  žž100 q BDR q ­ (9.14)
žŸ 360 ®­

Where:
BDR = the quoted yield (bank discount rate)

CALCULATING THE YIELD OF BONDS WITH A TERM TO MATURITY OF LESS THAN

ONE YEAR
The yield on bonds with a term to maturity of less than one year is quoted using a bond equivalent money market
yield rather than a conventional yield to maturity. This yield is calculated by first subtracting the total cost of the
bond (including accrued interest) from the total to be received at maturity (the principal and the last coupon
payment). The difference is a measure of the dollar return on the bond. The next step is to divide the dollar return
by the total price paid to get a measure of the holding period return. The final step is to divide 365 by the days to
maturity and multiply that by the holding period return to convert it to an annualized yield. The actual formula used
is very similar to Equation 9.11.
For a bond with a semi-annual coupon and only one interest payment remaining:
 Coupon ­¬ (9.15)
100žž1 ­  Price
žŸ 2 ­® 365
BEY  q
Price n
Where:
Coupon = semi-annual coupon rate
Price = cost of the bond with accrued interest
n = days to maturity

When there is only one coupon payment remaining, the one that gets paid at maturity, the yield is easy to calculate.
The calculation becomes a little more complicated when there is more than one coupon payment remaining. For
semi-annual pay bonds, there will be at most two coupon payments remaining, which occurs when there is more
than six months to maturity. The calculations are illustrated using two semi-annual pay bonds. The first has only
one coupon payment remaining and the second has two remaining.

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EXAMPLE
A Government of Canada 5% semi-annual coupon bond maturing September 1, 20X1, was offered at a price
of $100.76 and a quoted yield of 1.85%, for settlement on June 2, 20X1.
To compute the yield, begin by calculating the accrued interest that a buyer of this bond would pay to the seller.
From the most recent coupon payment date, March 1, to the June 2 settlement date, there are 93 days. Accrued
interest per $100 of face value is thus $1.27.
93
Accrued Interest Actual /365  5 q
365
 $1.27
Thus, the total cost of the bond is $102.03 ($100.76 + $1.27).
The next step is to calculate the total to be received at maturity (per $100 of face value), which in this case is
$102.50, equal to the principal ($100) plus the final coupon payment ($2.50 = $5/2).
The number of days from settlement to maturity is also needed to get the quoted yield; in this case it is 91.
With these three pieces of information, the quoted yield is calculated as follows:

102.50  102.03 365

Yield  q
102.03 91
0.47
 q 4.011
102.03
 0.004606 q 4.011

 0.0185

 1.85%

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We now turn to the slightly more difficult calculation using a bond with more than just one coupon payment
remaining.

EXAMPLE
A Province of Ontario 6.25% semi-annual coupon bond maturing March 8, 20X1, was offered at a price
of $103.04 and a quoted yield of 2.20%, for settlement on June 3, 20X0.
There are 87 days from the last coupon payment date to the settlement date, so the accrued interest per $100 of
face value is $1.49.
87
Accrued Interest Actual/365  6.25 q
365
 $1.49

The total cost of the bond is $104.53.

The total to be received at maturity (per $100 of face value) is $103.125, but in this case there is also a coupon
payment of $3.125 that will be paid on September 8, 20X0. The future value of this coupon payment (as of the
maturity date) gets added to the amount to be received at maturity when calculating the dollar return from this
bond. The rate typically used to calculate the future value is the yield on six-month T-bills and with six-month
Treasury bills yielding 2.08%, the future value of the September coupon payment is $3.1575.
 0.0208 ¬­
FV  $3.125 q žž1 ­
žŸ 2 ®­
 $3.125 q 1.0104

 $3.1575

The total amount to be received at maturity is, therefore, $106.2825 ($100 + $3.125 + $3.1575). Given that the
number of days from June 3, 20X0, to March 8, 20X1, is 278, the quoted yield is calculated as follows:
106.2825  104.53 365
Yield  q
104.53 278
1.7525
 q 1.31295
104.53
 0.0167655 q 1.31295

 0.0220

 2.20%

WHAT IS THE TERM STRUCTURE OF INTEREST RATES?

The term structure of interest rates is the relationship between interest rates and time to maturity. This
relationship is normally represented by a yield curve. Yield curves graphically represent the relationship between
bond yields and term to maturity for the debt securities of a single issuer. While a yield curve can be drawn for any
issuer with multiple bond issues outstanding, the yield curve most often used by investors is the one representing
the yield to maturity on benchmark federal government bonds.

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At any given time, the yield curve has a specific shape, which is generally characterized as normal, flat, or inverted:
• With a normal yield curve (also known as an upward-sloping yield curve), short-term interest rates are lower
than longer-term interest rates.
• With a flat yield curve, short-term interest rates are exactly or very close to longer-term rates.
• With an inverted yield curve (also known as a downward-sloping yield curve), short-term interest rates are
greater than longer-term rates.

Figure 9.1 | Types of Yield Curves

Normal Inverted
Yield

Yield
Maturity Maturity

Flat
Yield

Maturity

The yield curve is not static. Over time, the shape changes to reflect the market level of interest rates. Generally,
three types of shifts occur in the yield curve:

Parallel shifts Occur when yields at all maturities move up or down by the same or nearly the same
amount.

Twists Occur when yields toward one end of the yield curve move up or down by more than
yields at the other end, or when yields at one end move up or down while yields at the
other end move in the opposite direction. Twists cause the yield curve to steepen or
flatten.

Humps Occur when the yield at a certain maturity moves up or down independently or in a
greater amount than yields at all other maturities.

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Figure 9.2 | Types of Shifts in Yield Curves

Parallel Shifts Twists

Flattening
Parallel Shift Up
Yield

Yield
Steepening

Parallel Shift Down

Maturity Maturity

Humps

Positive Hump
Yield

Negative Hump

Maturity

Most yield curve shifts are either parallel or twists. Humps are rare. Normally, when the yield curve is upward-
sloping and it shifts upward, it also becomes flatter, as short-term yields rise more quickly than longer-term yields.
When the yield curve shifts downward, it normally becomes steeper, led by declines in short-term yields.

HOW ARE DEBT SECURITIES PRICES DETERMINED?

The Canada yield curve depicts the yield to maturity on the Government of Canada’s seven benchmark securities:
three-month, six-month, and one-year T-bills; and two-, five-, ten-, and thirty-year bonds. These securities are
issued at regularly scheduled auctions. When a new benchmark security is issued, it eventually becomes the on-the-
run issue for that benchmark maturity. Old benchmark bonds are then said to be off-the-run bonds.
The prices of off-the-run Government of Canada bonds and non-Government of Canada bonds are based on a yield
spread over benchmark Canada bonds. This makes sense because, by virtue of the government’s ability to tax its
citizens and to print money, Government of Canada bonds are considered free of credit risk. Hence, no other issuer
can borrow Canadian dollars at a lower rate than the Government of Canada.
As explained in Chapter 8, credit risk is a primary concern in the bond market. All other issuers, even if they have the
same AAA credit rating that credit rating agencies assign to the Government of Canada’s Canadian-dollar debt, are
deemed to have some degree of credit risk. A portion of the spread used to price non-Government of Canada bonds
represents the market’s assessment of the issuer’s credit risk. The topic of spreads is discussed further after the
determination of Government of Canada yields is reviewed.

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GOVERNMENT OF CANADA YIELD CURVE DYNAMICS

Different theories about term structure attempt to explain why the yield curve has the specific shape that it does.
The theories do not, however, explain what creates expectations about interest rates, nor the specific shocks that
allow for temporary alterations and movements in the shape of the curve.
Over time, the yield curve will steepen, flatten, invert, or possibly take on irregular shapes, depending on
expectations for economic growth, inflation, monetary policy, fiscal policy, the supply of government debt
securities, and the impact of other financial markets.

ECONOMIC CYCLE: GROWTH AND INFLATION FACTORS

Generally, the economy moves in a cyclical pattern, which affects bond prices. Figure 9.3 depicts a typical economic
cycle.

Figure 9.3 | The Economic Cycle

Boom

Boom
Growth
GDP

Contraction Recovery

Growth Trough

Time

The various phases of the economic cycle flow from one to the other, but the length and extent of each phase
are uncertain.

During the growth phase, the volume of goods and services rises. To increase production further, more investment
is required, resulting in increasing credit demands. This demand pushes interest rates higher because the supply of
credit becomes less flexible and cannot meet the increase in demand.
During the boom phase, the economy continues to grow and eventually reaches a peak. The rising pace of growth
leads to increased employment and, as labour becomes scarce, wages rise. Demand for input materials such as base
commodities also rises. Rising prices, combined with continued demand for credit, push interest rates higher.
During the contraction phase, the economy has passed its peak after stretching the expansion too far. Too much
inventory, combined with high input costs and tight credit conditions, results in reduced profitability and therefore
reduced incentive to invest and expand further. The rate of price increases diminishes, production slows, and the
economy slows. Reduced prices and reduced demand for credit push interest rates lower.
During the trough phase, demand for goods and services is low, profits decline further, unemployment rises, and
the need for investment is reduced. With further reductions in price pressure, inflation declines and the demand for
credit remains low, resulting in further declines in interest rates.

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Table 9.3 summarizes the relationship between key economic variables and the stages of the economic cycle.

Table 9.3 | Key Economic Variables and the Economic Cycle

Growth Stage Boom Stage Contraction Stage Trough Stage

Output of goods Increasing Increases to peak Overabundance Decreases to

and services of supply leads to bottom
decreases

Employment Increasing Increasing Decreasing Decreasing

Prices (inflation) Increasing Increasing Decreasing Decreasing

Corporate profit Increasing Increasing Decreasing Decreasing

and investment

Interest rates Increasing Increasing Decreasing Decreasing

Debt market participants closely monitor economic data to gauge economic activity, and the release of new
statistics often affects expectations. Against a background of economic forecasts and market consensus estimates,
reports that are not in line with expectations can generally lead to price activity in both equity and debt markets.
For debt markets, stronger-than-expected growth and inflation numbers generally have a negative impact because
they are expected to affect borrowing supply and demand, and therefore interest rates.
Canadian economic statistics are extremely important in gauging Canadian economic performance and Canada’s
position relative to other industrialized economies. However, Canadian bond-market participants watch U.S.
economic data as well, given the importance of the U.S. economy to Canada and the rest of the world.
Canadian debt-market participants watch the following measures very closely.

MEASURES OF RECENT ECONOMIC ACTIVITY

Gross Domestic Product (GDP) is the total amount of goods and services produced in an economy. It is reported
in both nominal (current) and real (inflation-adjusted) dollars. Both numbers are also seasonally adjusted to
normalized annual rates. GDP growth rates are important barometers of the economic cycle, and growth in real
GDP is the key measure of an economy’s actual increase in output over time.
Employment numbers indicate the number of people employed in an economy. They are normally accompanied
by the unemployment rate, which represents the percentage of the labour force that is not employed and actively
looking for work. The level of and growth in employment are important in determining the stage of the economic
cycle and expected labour-cost pressures.
New and existing home sales, housing starts, and the number of building permits indicate the state of the housing
market, which in turn indicates current economic growth and future levels of consumer spending on durable goods,
such as furnishings and appliances.
Retail sales are an estimate of consumer spending on goods. Strong growth in retail sales indicates consumers’
current spending capacity and potential price pressure.
Industrial surveys, such as surveys of purchasing managers, combined with industrial production and capacity
utilization numbers, indicate activity in manufacturing and non-manufacturing sectors. In the United States, several
districts of the Federal Reserve System also survey manufacturing activity.
The trade balance is the difference between exports and imports of goods and services. This measurement can be
interpreted in different ways. Although a trade deficit (more imports than exports) is a negative signal because of

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the negative effect on GDP and the need to draw in capital to finance foreign liabilities, it can also signal strong
consumer demand.

MEASURES OF INFLATION
The Consumer Price Index (CPI) is a measure of retail prices paid for a standard basket of goods and services, and
serves as the standard measure for inflation. A large increase has a negative effect on financial markets because
inflation erodes the value of financial assets.
The Producer Price Index (PPI) in the United States is a measure of prices received by producers for a broad range
of goods and commodities. In Canada, comparable indices include the Industrial Product Price Index (IPPI) and the
Raw Materials Price Index (RMPI). These numbers indicate the future direction of the CPI index.
The GDP Price Deflator is released with GDP data and represents the broadest measure of inflation, covering all
goods and services purchased or produced in an economy. Given the scope of the measure, and the fact that it is
re-weighted according to output, it tends to be less volatile than the CPI or the PPI.

MEASURES OF FUTURE ECONOMIC ACTIVITY

Index of Leading Indicators is a composite index that attempts to anticipate future economic activity and therefore
the business cycle. It consists of an average of economic variables. This indicator tends to have little market impact
since most of its components are released before it is itself released.
Consumer confidence surveys measure consumers’ perceptions of national economic conditions. These types of
surveys reflect job availability, income, and spending assumptions. The numbers are widely followed as fairly reliable
indicators of future economic activity.

MONETARY POLICY
The monetary policy of central banks influences the availability and cost of money and credit. These monetary
conditions reflect the effect on the economy of both short-term interest rates and exchange rates.
The goals of monetary policy include fostering sustainable economic growth, increasing and maintaining
employment, ensuring price stability, and maintaining stable international financial transactions. The Bank of
Canada’s stated monetary policy goal is to contribute to rising living standards for all Canadians through low and
stable inflation. To do so, the Bank of Canada aims to keep the rate of inflation, as measured by the annual rate
of increase in the CPI ex-8 index,4 inside a range established jointly with the government. This target range is 1%
to 3%.
The Bank of Canada uses two primary tools to implement monetary policy: interest rate policy and open market
operations.

INTEREST RATE POLICY

Setting an official interest rate is the most noticeable monetary policy tool. Major financial institutions routinely
borrow and lend money to each other on an overnight basis to cover their transactions during the day. The official
interest rate indicates to major financial institutions the rate at which the central bank wants them to lend money
to one another in the overnight market. This interest rate is enforced indirectly since the central bank normally
acts as a lender of last resort to any financial institution that cannot cover its obligations with any other financial
institution on any given day. The Bank of Canada has a system to ensure trading in the overnight market stays
within an operating band. This band, which is 50 basis points wide, always has the Bank of Canada’s Target for the
Overnight Rate at its centre.

4
This index, also known as the core CPI, is a variant of the CPI that excludes the eight components with the most volatile prices: fruit,
vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, and tobacco products. The core CPI also excludes the
effect of changes in indirect taxes on the remaining CPI components.

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When a central bank changes short-term interest rates, it triggers changes in market interest rates and exchange
rates, which in turn affects overall demand by influencing spending and investment patterns through the cost of
credit. This, in turn, influences prices and the level of inflation.
Inversion of the yield curve, which occurs when short-term rates are higher than long-term rates, is usually the
direct result of the central bank sharply raising short-term rates.

OPEN MARKET OPERATIONS

Open market operations involve the purchase or sale of Treasury bills or government bonds by the Bank of Canada,
which in turn influences the overall money supply. When the Bank of Canada sells these securities, money is
withdrawn from the economy. Conversely, when the Bank of Canada buys these securities, money is added to the
economy.

FISCAL POLICY
Fiscal policy represents the spending a government undertakes to provide goods and services, and the way in which
the government finances these expenditures. Government spending, like consumer spending and investment,
stimulates the economy. Money spent on goods and services adds to overall growth. Likewise, taxation has a
dampening effect on the economy, reducing the money individuals and businesses have to spend and invest.
Although, according to economic theory, government spending can be used to influence the business cycle,
efforts to do so have generally not been successful. Fiscal policy has therefore become more influential in financial
markets based on the level of government spending and the amount of government debt resulting from this level of
spending.
There are two methods of financing government spending: taxation and borrowing. Whatever spending cannot be
financed by taxation, the government must borrow from lenders and investors. This borrowing led to the creation
of government debt markets, as governments issued Treasury bills and bonds to finance ongoing expenditures.
The level of borrowing directly affects the supply of debt in the market, which in turn directly affects the level of
longer-term interest rates. Furthermore, governments that borrow heavily often turn to foreigners for financing. In
so doing, government finances become more vulnerable to foreign demand, and this affects the risk premium that
government bonds command.

RELATIONSHIPS BETWEEN FINANCIAL MARKETS

Financial markets are inter-related. All are affected by economic cycles and by the flow of investment funds as
investors allocate their portfolios to maximize returns efficiently according to their own risk profiles. The value
of Canadian debt securities is therefore affected not only by domestic valuation, but also by valuations in other
countries’ debt markets, as well as exchange rates and the relative performance of equity and commodity markets.

FOREIGN DEBT MARKETS

The Canadian market for government bonds is highly liquid. Canadian government bonds attract foreign investors
who are seeking international and currency diversification and buy not only Canadian foreign-currency bonds
targeted at international investors, but also Canadian-dollar debt issues. Furthermore, Canadian government bonds
compete with foreign bond markets for investment by Canadian investors.
The relative valuation of different government debt securities therefore affects Canadian bond markets. Canadian
bonds trade in close step with U.S. Treasuries given the importance of the U.S. bond market globally, the
relationship between the two economies, and the proximity of the two markets. However, trade in Australian and
New Zealand government bonds is also closely related to Canadian bond markets given the similarities of the
economies and political systems to Canada’s in the eyes of international investors.

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FOREIGN EXCHANGE MARKETS

The globalization of financial markets has provided investors with greater access to international markets. Rates of
return for individual investors, however, are measured by the increase in the value of their assets measured in their
own currency.

EXAMPLE
Although a Canadian investor may expect a greater rate of return in the U.S. market, if this coincides with a
weakening of the U.S. dollar relative to the Canadian dollar, the return on the U.S. investment for a Canadian
investor will be reduced.

Furthermore, the flow of international funds based on exchange-rate expectations directly affects the demand for
debt securities, as short-term investment funds flowing into or out of a country often are invested in short-term
debt securities because of their relatively low risk.

EQUITY MARKETS
In building investment portfolios, most investors focus on two asset classes: debt and equity. Although the key
decision on “how much to own and how much to loan” is dictated in part by investment goals and risk tolerance,
the relative opportunity between the two markets also plays a role.
Strong equity markets draw investment funds away from debt markets, while soft equity markets create buying
interest in debt markets in a “flight to quality” to the safety of government-guaranteed investments. Furthermore,
economic growth cycles are generally a positive influence on corporate profits and equity markets, while growth can
have a negative effect on debt markets because of the prospect of rising interest rates.

COMMODITY MARKETS
Strong commodity markets generally have a negative influence on bond markets. First, rising commodity prices
reflect strong growth; more importantly, however, they directly indicate rising prices, and inflation negatively
affects bond markets. Finally, a rise in the prices of certain “investment” commodities, such as gold and other
precious metals, may reduce the relative attractiveness of debt securities.

SPREADS AND MARKET PRICING CONVENTIONS

Securities issued by the Government of Canada set the benchmark borrowing rate for all Canadian-dollar debt
securities. To attract capital, other borrowers must offer incentives. In most cases, incentives take the form of
additional yield, known as a spread.

WHAT IS A SPREAD?
A spread is the difference between the yields on two debt securities, normally expressed in basis points.

EXAMPLE
If the yield on Bond X is 5% and the yield on Bond Y is 5.55%, the spread of Bond Y over Bond X is 55 basis
points.

Equation 9.16 can be used to calculate the spread between two debt securities.
Spread = Yield on Bond Y – Yield on Bond X (9.16)

Spreads are used to compare the yield of one bond to another. In most cases, the bond used as the standard (Bond X
in Equation 9.16) is a Government of Canada bond. The spread between a bond and the Canada bond reflects the
difference in risk between the two securities.

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9 • 25

The previous section noted that the spread partly reflects the credit risk of non–Government of Canada bonds. In
fact, the spread reflects not only the credit risk, but all other incremental risks faced by the owners of the non–
Government of Canada bonds. Besides credit risk, the most significant incremental risks are option and liquidity risk.
In general, the greater the difference in the risks of the two securities, the larger the spread.

THE IMPORTANCE OF SPREADS

The entire Canadian bond market trades on the concept of spreads. The market moves according to flows in
benchmark government issues, as every trade in a bond almost always triggers another trade in a government bond
with a comparable term or duration, which in turn is priced relative to a benchmark issue. As a result, bond prices
can change frequently. If you do not understand the behind-the-scenes mechanics of bond trading, this is a difficult
concept to comprehend. The following example provides an illustration.

EXAMPLE
You are an investment advisor and one of your clients wants to buy $1 million face value of 10-year Province of
Ontario bonds. You call your trading desk for an offer price. The provincial bond trader, after first checking the
offer price on the Canada bonds, quotes you a price based on what he determines is an appropriate yield spread
over 10-year Canada bonds. You relay the quote to your client and she agrees to do the trade. You then tell the
trader that your client will buy the bonds at the offer price.
If the provincial trader is perfectly hedged, or flat, before the trade (that is, the trader either did not own
the bonds your client just bought or had previously covered any exposure to the 10-year Ontario bond), the
transaction will leave him short $1 million face value of Ontario 10-year bonds. Until he covers this short
position, he will likely hedge the interest rate risk by buying a duration-weighted equivalent amount* of 10-year
Canada bonds from your firm’s Government of Canada trader.
By hedging the interest rate risk of an Ontario bond with a Canada bond, the trader is exposed to the risk that the
spread on the Ontario bond relative to the Canada bond will narrow. If it does, the provincial trader may have to
cover the short position in the Ontario bond at a price that is relatively higher than the one at which he sold the
bond to your client. If, however, the spread widens, he can cover the short position and earn a profit.

For instance, suppose the provincial trader offered the Ontario bond to your client at a price based on a spread of
40 basis points over the 10-year Canada bond, which is currently yielding 2.25%. In other words, your client paid
a price based on a yield of 2.65%. Suppose also that the provincial trader bought a duration-weighted equivalent
amount of 10-year Canada bonds at a yield of 2.25%. In this case, he will realize a profit on his short-Ontario/
long-Canada position if he can offset both bonds when the spread is greater than 40 basis points.
If the trader offsets the positions when the spread is, say, 50 basis points, he covers the short position in the
Ontario bond at a price that is relatively lower than the price your client paid. If he offsets the positions when the
spread is, say, 30 basis points, then he covers the short position in the Ontario bond at a price that is higher than
the price your client paid.
Even though the provincial trader is hedged, the ripple effects of your client’s trade do not necessarily end there.
After the transaction between the provincial and Canada traders, the Canada trader is short $1 million in 10-year
bonds (assuming that she was flat the 10-year bond). To cover the short position, the Canada trader needs to find
10-year bonds elsewhere: maybe because she is asked to bid on 10-year Canada bonds by another trader in the
firm. If she cannot offset the bond internally, she can buy the bonds from another dealer through an inter-dealer
bond broker.
As this flow of trade continues, the market on 10-year bonds will be affected. If, for instance, there was sharp
client demand for 10-year bonds at several dealers, all the Canada dealers would be left short. They would then
bid the price up at the inter-brokers until another dealer or client feels the market is too rich and decides to sell.

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EXAMPLE
Cont'd
What other options does the Canada trader have? She could try to hedge with bonds of another term – perhaps
9- and 11-year bonds; however, this is not a perfect hedge because the spread between the 10-year and the 9-
and 11-year bonds depends on the overall shape of the yield curve, and this spread can change at any time.
Alternatively, the 10-year Canada trader can turn to foreign bond markets. Although the Canada market is highly
liquid, the larger U.S. Treasury market is even more liquid. Therefore, when traders cannot find a Canada bond
to cover their short positions, they often buy U.S. Treasuries instead. Again, this is not a perfect hedge. There is
currency exposure to contend with and the spread between Canada and U.S. yields can change. Nonetheless, the
high correlation between the two markets makes U.S. Treasuries a common option for hedging Canada bonds.

* Buying a duration-weighted equivalent amount of Canada bonds means that, if interest rates change and the spread between the
Ontario and Canada bond remains the same, the dollar change in the price of the Canada bond will be approximately equal to the dollar
change in the price of the Ontario bond. Since the trader is short the Ontario bond and long the Canada bond, the dollar changes offset
one another and the trader has hedged the risk of the short Ontario bond position (assuming, again, that the spread is unchanged).

The Canada traders therefore represent the linchpin of the Canadian bond market. Their role is crucial in all trade
flow, and their actions and reactions play a large part in determining price relationships in the overall bond market.

SPREAD DETERMINATION
The basic premise behind spreads is that they compensate investors for taking on risks above and beyond the risks
associated with Government of Canada bonds. The primary risks incurred by investors in non–Government of
Canada bonds are credit risk, option risk, and liquidity risk.

CREDIT RISK
Credit risk is the most important determinant of a bond’s spread. The portion of a bond’s spread attributable to the
difference in credit risk is known as the credit spread.
Non-callable bonds with a higher credit rating trade at lower credit spreads than non-callable bonds with
lower credit ratings. For example, AAA-rated British Columbia bonds have lower credit spreads than A-rated
Newfoundland bonds. Even though British Columbia has the same credit rating as Canada, British Columbia bonds
still have a credit spread, reflecting the Government of Canada’s larger tax base and its ability to print money.
(A portion of the spread between Canada bonds and non-callable British Columbia bonds is also due to liquidity risk,
discussed below.)
Table 9.4 shows the difference in yields between similar-term Government of Canada bonds, Province of Ontario
bonds, and a hypothetical AA-rated corporate bond. As the table shows, the yield on the AA bonds is higher than
the yield on the Province of Ontario bonds, which is higher than the yield on the Canada bonds. Furthermore, as the
term of the bonds increases, the yield spreads get bigger because the time frame during which a potentially negative
credit event can occur is longer.

Table 9.4 | Credit Spreads

Government of Province of Spread AA Corporate Spread

Canada Yield Ontario Yield (In Basis Points) Yield (In Basis Points)
2-year 1.28% 1.36% 8 1.52% 24
5-year 1.33% 1.55% 22 1.80% 47
10-year 2.28% 2.58% 30 2.87% 59

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9 • 27

OPTION RISK
Most bonds issued in Canada today contain some type of option. The effect of the option on the spread of the bond
relative to an otherwise equivalent option-free bond depends on whether or not the option benefits the issuer or
the investor.
If the option benefits the issuer, the spread will be greater than the spread of an otherwise equivalent option-free
bond; if the option benefits the investor, the spread will be less. There are three primary types of embedded options:
calls, puts, and conversions. Call options benefit the issuer, while put options and conversion options benefit
the investor.
To compensate investors for the possibility of having their bonds called before maturity, callable bonds must be
offered with a spread that is greater than the spread of an otherwise equivalent non-callable bond with the same
credit risk.
For example, Table 9.5 compares the yield on a hypothetical callable bond to the yields on Government of Canada
bonds and the yields on hypothetical non-callable bonds of the same issuer. For each potential maturity date, the
callable bond offers a higher yield than the Canada bonds and the non-callable bonds, representing the uncertainty
regarding when the bond will be called.

Table 9.5 | Spreads Due to Option Risk

Callable Bond Yield Government of Spread Non-Callable Bond Spread

to Call/Maturity Canada Yield (In Basis Points) Yield (In Basis Points)
1 3.10% 1.97% 113 2.17% 93
2 3.17% 2.22% 95 2.48% 69
3 3.28% 2.61% 67 2.88% 40
4 3.45% 3.02% 43 3.37% 8

Unlike callable bonds, bonds with an embedded put or conversion option can be offered with a spread that is less
than the spread of an otherwise equivalent option-free bond because these options have value for investors.

LIQUIDITY RISK
The benchmark Government of Canada bonds are the most liquid bonds in the Canadian market. Daily turnover of
these bonds is normally many times that of most other bonds, including off-the-run Government of Canada bonds.
A lower level of liquidity translates into greater risk for investors because of the wider bid-ask spread associated
with less-liquid issues. This means that the bond must be bought or sold at a value further from its true value, which
is represented by the mid-point of the bid-ask spread.
Table 9.6 shows what typical bid-ask spreads, in terms of both price and yield, could look like on 10-year
Government of Canada bonds, Province of Ontario bonds, Royal Bank bonds, and Shaw Communications bonds. The
progressively higher bid-ask yield spread for the different issuers represents increasing liquidity risk.

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Table 9.6 | Spreads Due to Liquidity Risk

Bid Ask Bid Ask Bid-Ask

Price Price Yield Yield Yield Spread
Government of Canada $107.250 $107.300 2.285% 2.278% 0.007%
Province of Ontario $111.267 $111.337 2.578% 2.569% 0.009%
Royal Bank $114.500 $114.800 2.863% 2.818% 0.045%
Shaw Communications $115.360 $116.360 4.733% 4.595% 0.138%

Spread product traders (traders of all non–Government of Canada bonds) must consider credit, option, and liquidity
risk when they determine the appropriate yield spread for an issue. They do this on a continual basis, relying on
trade flow to indicate the accuracy of their pricing. For example, if they are continually being asked to bid on the
bonds of one issuer, they will increase (widen) the bonds’ yield spreads until the bonds are low enough in price to
spark interest from buyers. Conversely, if they are continually being asked to offer the bonds of one issuer, they will
reduce (tighten) the bonds’ yield spreads until they find the level that entices sellers into the market.

SPREAD BEHAVIOUR
There are two basic theories behind the behaviour of spreads. The quality spread theory attempts to explain the
behaviour of credit spreads. The interest rate volatility theory attempts to explain the behaviour of callable bond
spreads.

QUALITY SPREAD THEORY

The quality spread theory is based on the view that credit spreads are affected by the economic cycle. During
an economic recovery, the perception of the quality and safety of non–Government of Canada issues improves.
Investors are more comfortable shifting funds to riskier assets to generate higher returns. As more money moves
into the lower-credit bonds, the price relative to Canada bonds rises and spreads begin to tighten. Conversely,
during an economic downturn, the perception of the quality and safety of non–Government of Canada issues falls
and investors shift funds back into Government of Canada debt. This is known as a flight to quality.

INTEREST RATE VOLATILITY THEORY

Interest rate volatility theory is used to explain the behaviour of the portion of a bond’s spread that is due to
embedded options. According to this theory, in times of high interest-rate volatility, yield spreads on callable bonds
widen and yield spreads on putable bonds narrow. As volatility subsides, the opposite is true, with the spreads on
callable bonds narrowing and the spreads on putable bonds widening. Higher volatility increases the value of both
call and put options; lower volatility decreases their value.
In times of high interest rate volatility, embedded call options become more valuable to the issuer because the
issuer owns the option, thus the price of the bond falls. The falling bond price results in a greater yield, which
translates into a wider yield spread compared to non-callable Government of Canada bonds. Conversely, when
interest-rate volatility subsides, the value of the option falls, callable bond prices rise, and the spreads are
compressed.
Putable and redeemable bonds, which are much rarer in Canada, react in the opposite way. With putable bonds,
the investor owns the option. When interest-rate volatility increases, the value of the put option increases,
which increases the value of the bond, causing yield spreads to shrink relative to Government of Canada bonds.
Conversely, when interest-rate volatility declines, putable bond prices fall and yield spreads widen.

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 CHAPTER 9 | ANALYSIS OF DEBT SECURITIES I: VALUATION, TERM STRUCTURE, AND PRICING 9 • 29

SUMMARY
By the end of this chapter, you will be able to:
1. Calculate the price, accrued interest, or yield of any debt security.
• Price calculations include: strip coupon and residual prices, bond prices given the yield to maturity, money
market prices given their yield.
• There are four different day count methods: actual/365, actual/actual, actual/360, and 30/360.
• Yield calculations include: strip coupon and residual yields, yield to maturity of bonds given their price, yield
of bonds with embedded call or put options, yield of a bond portfolio, money market yield given their price,
and yield on bonds with a term to maturity of less than one year.

2. Describe what is represented by various yield curve shapes.

• With a normal yield curve (also known as an upward-sloping yield curve), short-term interest rates are lower
than longer-term interest rates.
• With a flat yield curve, short-term interest rates are exactly or very close to longer-term rates.
• With an inverted yield curve (also known as a downward-sloping yield curve), short-term interest rates are
greater than longer-term rates.

3. Explain the pricing of bonds against a benchmark yield curve.

• Spreads compensate investors for taking on risks above and beyond the risks associated with Government of
Canada bonds. The primary risks incurred by investors in non-Government of Canada bonds are credit risk,
option risk, and liquidity risk.
« Credit risk: Credit risk is the most important determinant of a bond’s spread. The portion of a bond’s spread
attributable to the difference in credit risk is known as the credit spread.
« Option risk: The effect of the option on the spread of the bond relative to an otherwise equivalent option-
free bond depends on whether or not the option benefits the issuer or the investor.
« Liquidity: A lower level of liquidity translates into greater risk for investors because of the wider bid-ask
spread associated with less-liquid issues.

© CANADIAN SECURITIES INSTITUTE (2017)

 Analysis of Debt Securities II:
Price Volatility and Investment 10
Strategies

CONTENT AREAS

What Are the Key Concepts Relating to Bond Price Volatility?

What Are Debt Securities Strategies?

LEARNING OBJECTIVES

1 | Calculate and explain the relationship between bond prices, duration, and convexity.

2 | Calculate bond price changes due to duration or convexity.

3 | Choose debt strategies that respond to appropriate objectives to create bond portfolios.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 3

INTRODUCTION
The price of a debt security is inversely related to its yield, so that when its yield rises, its price falls, and vice versa.
Exactly how much the price of a debt security is expected to change for a given change in yield is a widely used
measure of risk in the debt securities market. In general, the greater the expected change in price for a given change
in yield, the more risky the debt security. Understanding the risk of debt securities can help investment advisors
develop strategies to take advantage of interest rate forecasts.
This chapter begins with a review of the price-yield relationship of debt securities, and then gets into a detailed
discussion of duration and convexity, two important measures of price volatility. The chapter concludes with a
discussion of several investment strategies for debt securities.

WHAT ARE THE KEY CONCEPTS RELATING TO BOND PRICE

VOLATILITY?

FUNDAMENTAL RELATIONSHIPS BETWEEN BOND PRICES AND YIELDS

A fundamental property of all option-free bonds1 is that bond yields are inversely related to bond prices. That is,
all else being equal, when the yield of a bond increases, the price falls, and when the yield falls, the price increases.
Table 10.1 shows this property for nine different semi-annual coupon, option-free bonds.

Table 10.1 | Bond Prices at Different Yield Levels

Yield 0% Coupon 0% 0% 5% 5% 5% 10% 10% 10%

(%) 2-Year 10-Year 20-Year 2-Year 10-Year 20-Year 2-Year 10-Year 20-Year

4.00 92.38 67.30 45.29 101.90 108.18 113.68 111.42 149.05 182.07

4.50 91.48 64.08 41.06 100.95 103.99 106.55 110.41 143.90 172.03

4.90 90.77 61.63 37.98 100.19 100.78 101.27 109.60 139.94 164.55

4.99 90.61 61.09 37.32 100.02 100.08 100.13 109.42 139.07 162.94

5.00 90.60 61.03 37.24 100.00 100.00 100.00 109.40 138.97 162.76

5.01 90.58 60.97 37.17 99.98 99.92 99.87 109.38 138.88 162.58

5.10 90.42 60.43 36.52 99.81 99.22 98.76 109.21 138.01 160.99

5.50 89.72 58.13 33.79 99.07 96.19 93.98 108.41 134.26 154.18

6.00 88.85 55.37 30.66 98.14 92.56 88.44 107.43 129.75 146.23

The inverse relationship between bond prices and yields is not linear. The price-yield line is convex, and this shape
indicates a distinct property of bond price volatility: as yields fall, prices rise at an increasing rate; as yields rise,
prices fall at a decreasing rate.
Bond price volatility can be measured by the absolute dollar change or the percentage change in the bond price for
a given change in yield. Assuming all nine bonds from Table 10.1 initially traded with a yield of 5%, Table 10.2 shows
the percentage change in the price of the bonds if the yield instantaneously changes to the new yield in the first
column.

1
For the remainder of this section, our discussion will focus almost entirely on option-free bonds.

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10 • 4 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

Table 10.2 | Percentage Price Changes When Yields Change Instantaneously

Yield 0% Coupon 0% 0% 5% 5% 5% 10% 10% 10%

(%) 2-Year 10-Year 20-Year 2-Year 10-Year 20-Year 2-Year 10-Year 20-Year

4.00 1.98 10.27 21.60 1.90 8.18 13.68 1.84 7.25 11.86

4.50 0.98 5.01 10.26 0.95 3.99 6.55 0.92 3.55 5.70

4.90 0.20 0.98 1.97 0.19 0.78 1.27 0.18 0.70 1.10

4.99 0.02 0.10 0.20 0.02 0.08 0.13 0.02 0.07 0.11

5.01 -0.02 -0.10 -0.19 -0.02 -0.08 -0.13 -0.02 -0.07 -0.11

5.10 -0.19 -0.97 -1.93 -0.19 -0.78 -1.24 -0.18 -0.69 -1.09

5.50 -0.97 -4.76 -9.28 -0.93 -3.81 -6.02 -0.91 -3.39 -5.27

6.00 -1.93 -9.27 -17.69 -1.86 -7.44 -11.56 -1.80 -6.63 -10.15

Table 10.2 illustrates three key features of bond price volatility:

• For a given change in yield, the percentage change in the price of the different bonds is not the same. For example,
if the yield decreases from 5% to 4.50%, the percentage price change for the two-year, 0% coupon bond is
different from that of the two-year, 5% coupon bond and from that of the two-year, 10% coupon bond, and
each of these differs from the percentage change for all the other bonds in the table.2
• For very small changes in a bond’s yield, the percentage change in price is the same whether the yield increases or
decreases. For example, if the yield decreases from 5% to 4.99% or increases from 5% to 5.01%, for each bond
in the table the percentage price change positive and negative is the same.3
• For larger changes in a bond’s yield, the percentage change in price for an increase in yield is less than the
percentage change in price for an equivalent decrease in yield. For example, if the yield increases from 5% to
5.50%, the size of the percentage price change for each bond is less than the size of the change when the yield
decreases from 5% to 4.50%.

These three key features are true of bond price volatility in terms of absolute dollar price change as well as the
percentage price change. Table 10.2 reveals two other features that are true for percentage price changes but are not
necessarily true when price changes are measured in terms of absolute dollars:
• For bonds with the same coupon rate and yield, a given change in yield will result in a greater percentage price
change for longer-term bonds than for shorter-term bonds. For example, if yields decrease from 5% to 4.50%, the
percentage price change for the 20-year, 5% coupon bond is greater than that for the 10-year, 5% coupon bond,
which in turn is greater than that for the 2-year, 5% coupon bond.
• For bonds with the same term to maturity and yield, a given change in yield will result in a greater percentage price
change for bonds with lower coupon rates than for bonds with larger coupon rates. For example, if yields decrease
from 5% to 4.50%, the percentage price change for the 10-year, 0% coupon bond is greater than that for the
10-year, 5% coupon bond, which in turn is greater than that for the 10-year, 10% coupon bond.

2
The percentage price change for all of the two-year bonds given a one-basis-point change is the same when rounded to two decimal places.
When calculated to more decimal places, the change is different.
3
The lone exception is the 20-year, 0% coupon bond. This hints at an exception to this key feature: the smaller the coupon rate and the
longer the term to maturity, the greater the likelihood a small increase in yield will produce a different percentage price change than a small
decrease in yield.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 5

MEASURING BOND PRICE VOLATILITY: DURATION AND CONVEXITY

The volatility of bond prices, as measured by instantaneous percentage price changes, depends primarily on two of
the bond’s features: the coupon rate and the term to maturity. Table 10.3 shows the difference in price on both a
dollar and percentage basis of the 10-year bonds shown in Table 10.1, given a change in yield from 5% to 4.50%.

Table 10.3 | Dollar and Percentage Price Change for Three 10-Year Bonds

Price with Price with Dollar Percentage

Coupon Yields at 5% Yields at 4.50% Price Change Price Change*
0% $61.03 $64.08 $3.05 5.01%
5% $100.00 $103.99 $3.99 3.99%
10% $138.97 $143.90 $4.93 3.55%

* For example, for the 10% coupon, ($143.90 – $138.97)/$138.97 = 0.03547. Next, 0.03547 x 100 = 3.547% (rounded to 3.55%).

Although the dollar price change for higher-coupon bonds is greater, the percentage price change is lower. Therefore,
for two bonds with the same term to maturity and the same yield, the bond with the lower coupon is more volatile
than the bond with the larger coupon.
Again referring to data in Table 10.1, Table 10.4 shows the difference in the dollar and percentage price changes for
the three bonds with coupon rates of 5%, given a change in yield from 5% to 4.50%.

Table 10.4 | Dollar and Percentage Price Change for Three Bonds With Coupon Rates of 5%

Term Price with Price with Dollar Percentage

to Maturity Yields at 5% Yields at 4.50% Price Change Price Change
2 years $100.00 $100.95 $0.95 0.95%
10 years $100.00 $103.99 $3.99 3.99%
20 years $100.00 $106.55 $6.55 6.55%

For two bonds with the same coupon rate and the same yield, the bond with a longer term to maturity is more
volatile than the bond with the shorter term to maturity. These two factors, coupon rate and maturity, influence
bond prices significantly.

DURATION
It is relatively straightforward to compare bonds with the same term to maturity or the same coupon rate, but how
can the volatility of bonds that have different coupon rates and different maturities be compared? The answer is a
measure that combines the impact of both the coupon rate and the term to maturity, known as duration.
Three different measures of duration are commonly used: Macaulay, modified, and effective duration. For option-
free bonds, modified duration is equal to effective duration, so the discussion that follows is limited to Macaulay
and modified duration only.

MACAULAY DURATION
A bond’s Macaulay duration is the weighted-average term to maturity of the present value of the bond’s cash
flows, including all coupon payments and the principal repayment. The weight given to each coupon payment
is equal to the present value of the payment divided by the price of the bond. The present value of each coupon
payment is determined using the bond’s yield to maturity. Defined this way, Macaulay duration can be thought of as

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10 • 6 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

the average life of a bond measured in years. Equation 10.1 is used to calculate the Macaulay duration of a bond on a
coupon payment date.
T qk
(10.1)
œ t q PVCF
t 1
t
Macaulay Duration 
k q Price
Where:
T = the number of years to maturity
t = time period
PVCF t = the present value of the cash flow at time t discounted at the bond’s yield to maturity
k = the number of coupon payments per year

Because of the potentially large number of calculations involved, Macaulay duration is normally determined using
financial calculators or computer software; however, it is useful to understand how the calculation is performed.
For example, a 10-year, 5% bond with two coupon payments a year and a semi-annual yield of 5% trades at a price
of $100. Table 10.5 breaks down the calculation of this bond’s Macaulay duration.

Table 10.5 | Calculating Macaulay Duration

Time To Cash Flow Cash Flow Present Value Of Time X Present

(In Half-Years) At Time T The Cash Flow Value The Cash Flow
t CFt PVCF t t x PVCFt
1 $2.50 $2.4390 2.4390
2 $2.50 $2.3795 4.7590
3 $2.50 $2.3215 6.9645
4 $2.50 $2.2649 9.0596
5 $2.50 $2.2096 11.0480
6 $2.50 $2.1557 12.9342
7 $2.50 $2.1032 14.7224
8 $2.50 $2.0519 16.4152
9 $2.50 $2.0018 18.0162
10 $2.50 $1.9530 19.5300
11 $2.50 $1.9054 20.9594
12 $2.50 $1.8589 22.3068
13 $2.50 $1.8136 23.5768
14 $2.50 $1.7693 24.7702
15 $2.50 $1.7262 25.8930
16 $2.50 $1.6841 26.9456
17 $2.50 $1.6430 27.9310
18 $2.50 $1.6029 28.8522
19 $2.50 $1.5638 29.7122
20 $102.50 $62.5528 1,251.0560
Totals $100.00 1,597.8913

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 7

The final step in the calculation is to divide 1597.8913 by 200 (2 u the bond’s price) to get the bond’s Macaulay
duration of 7.99.
An interesting result occurs when we calculate the Macaulay duration of a zero-coupon bond (or strip coupon). As
it turns out, the Macaulay duration in this case is the same as the bond’s term to maturity. For example, a five-
year strip coupon trading at $82.20 (per $100 of face value) and with an annual yield of 4% will have a Macaulay
duration of exactly 5. This is true whether we calculate Macaulay duration using the annual or the semi-annual yield.
The more important challenge, however, is understanding what the Macaulay duration actually means and how
it can be used. As it turns out, interpreting Macaulay duration as the average life of a bond does not mean much
on its own. The duration’s real worth is that it can be used to calculate a much more useful measure of bond price
volatility: modified duration.

MODIFIED DURATION
A bond’s modified duration is a measure of the approximate percentage price change for a 100-basis-point change
in yield. Given the bond’s Macaulay duration, Equation 10.2 can be used to calculate modified duration.
Macaulay Duration (10.2)
Modified Duration 
1 y k

Where:
y = yield
k = number of coupon payments per year

EXAMPLE
If the Macaulay duration of a 10-year, 5% semi-annual coupon bond yielding 5% is 7.99, its modified duration
is 7.80.
7.99/(1 + 0.05/2)
= 7.99/(1 + 0.025)
= 7.99 / 1.025
= 7.80

The modified duration can be used to determine the approximate percentage price change of a bond given a certain
change in the bond’s yield. Of course, percentage price changes can be calculated simply by taking the percentage
change in two bond prices, as we did many times to produce Table 10.1. With modified duration, however, it is easy
to calculate the approximate percentage price change from a given yield to any other yield using the modified
duration and the change in yield. We no longer need to calculate the bond price at the new yield level. The trade-off
for this ease and flexibility is that duration provides only an approximation of the percentage price change rather
than an exact figure, which is discussed in greater detail later in this chapter.
Given a bond’s modified duration and a change in yield, Equation 10.3 can be used to calculate the approximate
percentage price change of a bond.
Approximate Percentage Price Change = –Modified Duration × Δ y × 100 (10.3)

Where:
Δ y = the change in yield expressed as a decimal

The minus sign in front of the modified duration value indicates the inverse relationship between price and yield
changes.

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10 • 8 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

EXAMPLE
The yield on a 10-year, 5% semi-annual coupon bond falls from 5% to 4.50%. Using the bond’s modified
duration of 7.80, we can determine that the price of the bond will increase by approximately 3.90%.
Approximate Percentage Price Change = –7.80 × (–0.005) × 100 = 3.90%

Table 10.6 lists the modified duration of the bonds in Table 10.1 at yields of 4%, 5%, and 6%.

Table 10.6 | Modified Duration of Bonds in Table 10.1 at Yields of 4%, 5%, and 6%

Modified Duration
Term Coupon Rate Yield = 4% Yield = 5% Yield = 6%
0% 1.96 1.95 1.94
2 Years 5% 1.89 1.88 1.87
10% 1.83 1.82 1.81
0% 9.80 9.76 9.71
10 Years 5% 7.88 7.80 7.67
10% 7.04 6.93 6.79
0% 19.61 19.51 19.41
20 Years 5% 13.09 12.55 12.01
10% 11.47 10.96 10.46

Table 10.6 illustrates a number of properties of modified duration:

• All else being equal, the longer the term to maturity, the greater the modified duration. For example, for a given
yield and coupon rate, the modified duration of the 20-year bond is greater than the modified duration of the
10-year bond, which is greater than the modified duration of the 2-year bond.
• All else being equal, the lower the coupon rate, the greater the modified duration. For example, for a given yield
and term to maturity, the modified duration of the 0% bond is greater than the modified duration of the 5%
bond, which is greater than the modified duration of the 10% bond.
• All else being equal, the lower the yield, the greater the modified duration. For example, for a given coupon rate
and term to maturity, the modified duration at a yield of 4% is greater than the modified duration at a yield of
5%, which is greater than the modified duration at a yield of 6%.
• Modified duration is always less than the term to maturity.

Understanding the meaning of a bond’s modified duration leads to how it can be used. Suppose an investor expects
interest rates to drop significantly. The investor wants to position his bond portfolio to earn as great a return as
possible from the expected decline in interest rates. What should the investor do?
Since a greater modified duration translates into a greater percentage price change for a given change in yield, the
investor would earn the greatest return from an expected decline in interest rates by investing in bonds with the
greatest modified duration. Without even knowing the specific modified duration of the bonds available to him,
the first and second points listed above suggest that he needs to buy bonds with long maturities and low coupon
rates. If he does this and interest rates fall, he will earn a greater return than if he had invested in bonds with shorter
maturities and higher coupon rates.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 9

PORTFOLIO MODIFIED DURATION

The modified duration of a portfolio of bonds is a weighted average of the individual bond modified durations;
the weights equal the market value proportions of each bond within the portfolio. Equation 10.4 can be used to
calculate the modified duration of a portfolio of bonds.
N
MVi (10.4)
Portfolio Modified Duration  œD
i 1
i q
MVp

Where:
N = the number of bonds in the portfolio
Di = the modified duration of bond i
MVi = the market value of bond i
MVp = the market value of the bond portfolio

EXAMPLE
A two-year, 5% semi-annual coupon bond is trading at $100 to yield 5% and a ten-year, 0% coupon bond is
trading at $55.37 to yield 6%. The modified duration of the two-year bond is 1.88 and the modified duration of
the ten-year bond is 9.71. An investor who owns $50,000 face value of the two-year bond and $50,000 face value
of the ten-year bond wants to know the modified duration of her portfolio.
First, calculate the market value and market value weights of the two bonds in the portfolio. Based on current
prices, the market value of the two-year bond is $50,000 ($50,000 × ($100/$100)) and that of the ten-year
bond is $27,685 ($50,000 × [$55.37/$100]). The total market value of the portfolio is $77,685. The modified
duration of the investor’s bond portfolio is 4.67 based on the calculation shown below.

 $50,000 ¬­  $27,685 ¬­
Portfolio Modified Duration  žž1.88 q ­ žžž9.71 q ­
Ÿž $77,685 ­® Ÿ $77,685 ­®

 1.88 q 0.6436 9.71 q 0.3564

 1.21 3.46

 4.67

If the modified duration of an individual bond is the approximate percentage price change for a 100-basis-point
change in the yield of the bond, what is portfolio modified duration? Portfolio modified duration tells us the
approximate percentage price change in the value of the portfolio for a 100-basis-point change in the yields of all
bonds in the same direction. In other words, if the yield on the two-year, 5% semi-annual coupon bond fell by 100
basis points to 4%, and at the same time the yield on the ten-year, 0% coupon bond fell by 100 basis points to 5%,
then the portfolio’s market value would increase by approximately 4.67%.

YIELD TO MATURITY ON A BOND PORTFOLIO REVISITED

Chapter 9 explained how to use a cash flow schedule to calculate the yield to maturity of a bond portfolio. It was
noted that the yield to maturity of a bond portfolio was not equal to the weighted average of the yield to maturity
of the individual bonds within the portfolio. Chapter 9 also hinted that the modified duration of the bonds within
a bond portfolio could be used to calculate the yield to maturity more quickly. The following shows how to use the
modified duration of individual bonds to determine the yield to maturity of a bond portfolio.

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Suppose the investor in the previous example wants to know the yield to maturity of her portfolio of two bonds. If
the investor thought that the yield was a weighted average of the yields on the two bonds, she would calculate the
yield to maturity of the bond portfolio as follows:

Weighted Average Portfolio Yield to Maturity = (5% × 0.6436) + (6% × 0.3564)

= 3.218% + 2.138%
= 5.36%

Using the cash flow analysis presented in Chapter 9, a financial calculator computes the actual yield to maturity
as 5.74%.
There is an easier way to calculate the yield to maturity of a bond portfolio, however, using the bonds’ modified
durations as the weights. The yield to maturity of a bond portfolio can be calculated as the duration-weighted yield
to maturity of the individual bonds in the portfolio. Equation 10.5 shows the formula.
MVi (10.5)
N
Di q
MVp
Portfolio Yield to Maturity  œY q
i 1
i
Dp

Therefore, the yield to maturity of the above portfolio is:

 $50,000 ¬­  $27,685 ¬­
žž 1.88 q ­ žž 9.71 q ­
žž $77,685 ­­­ žž $77,685 ­­­
Portfolio Yield to Maturity  ž5% q žž6% q
žž 4.67 ­­­ žž 4.67 ­­­
žž ­­ ­
Ÿ ® žŸ ®­

 1.2100 ­¬  ¬
 žž5% q ­ ž6% q 3.4604 ­­
žŸ 4.67 ­® žžŸ 4.67 ® ­

 5% q 0.2591 6% q 0.7410

 1.2955% 4.446%

 5.74%

The yield to maturity calculated using duration weights is, therefore, the same as it is using the cash flow schedule.

DOLLAR DURATION
Modified duration is used to determine the approximate percentage price change in a bond or bond portfolio.
Sometimes, however, it is useful to know the approximate change in absolute dollar value of a bond or portfolio
for a given change in yield. Given the modified duration of a bond or bond portfolio, Equation 10.6 can be used to
calculate the dollar duration of the bond or bond portfolio for a 100-basis-point change in yields.
Approximate Dollar Change = –Modified Duration × Δ y × MV (10.6)

Where:
MV = the market value of a bond or bond portfolio

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 11

EXAMPLE
The modified duration of a 10-year, 5% semi-annual coupon bond when it yields 5% is 7.80. We can calculate
the dollar duration of the bond for each $100 of face value by substituting the price of the bond for the MV term
in Equation 10.6. Thus, given a 50-basis-point increase in the bond’s yield from 5% to 5.50%, Equation 10.6
estimates that the price of the bond will fall by $3.90 to $96.10.*
Approximate Dollar Change = –7.80 × (0.005) × $100 = –$3.90

Suppose an investor holds $50,000 face value of this bond and wants to know how much the value of this
position would decline for an increase in yield of 50 basis points. Multiply the $3.90 dollar duration per $100 of
face value by 500, which is the total number of $100-face-value bonds the investor holds. Alternatively, plug the
$50,000 market value of the bond (given that its price is $100) directly into Equation 10.6.
Approximate Dollar Change = –7.80 × (0.005) × $50,000 = –$1,950

Thus, given the 50-basis-point increase in the bond’s yield from 5% to 5.50%, the market value of the investor’s
position can be expected to decline by approximately $1,950.

* 50 basis points equals 0.50%, and as a reminder, in decimals, 0.50% equals 0.005.

The same procedure used in the portfolio modified duration example is used to calculate the dollar duration of
a bond portfolio. The market value of the portfolio can be used directly to figure out how much the value of the
portfolio will change given a specific change in the yields of all bonds in the portfolio.

DURATION AS AN APPROXIMATE PERCENTAGE PRICE CHANGE

Duration works as an approximate measure of a bond or bond portfolio’s volatility only if two assumptions hold
true: 1) the changes in yield to maturity are small, and 2) the yield curve shifts in a parallel manner.
For instance, Table 10.2 shows that the actual percentage price change of the 10-year, 5% semi-annual coupon
bond when yields fall from 5% to 4% is 8.18%. But in Table 10.6, the modified duration of the 10-year, 5% semi-
annual coupon bond when it yields 5% turns out to be 7.80%. In other words, modified duration understates the
actual percentage price change when the yield falls. A quick check of Tables 10.2 and 10.6 shows that this is true in
all cases.
What happens when yields rise to, say, 6%? Modified duration says the bond price will fall by 7.80%, but we know
from Table 10.2 that the price of the bond actually falls by only 7.44%. Thus, when yields rise, modified duration
overstates the actual percentage price change.4
This asymmetry in percentage price changes was noted in the summary of the key features of bond price volatility;
however, modified duration does not take the asymmetry into account and instead produces symmetrical
percentage price changes for both increases and decreases in yield. The following section looks more closely at the
source of the asymmetry and why duration fails to capture this aspect of bond price volatility.

CONVEXITY
The asymmetry in percentage price changes and the inability of modified duration to capture this asymmetry is
directly related to the convex nature of the price-yield relationship. Figure 10.1 shows this convexity, along with a
straight line that represents modified duration.

4
If modified duration understates the actual percentage price change when yields fall and overstates the actual percentage price change when
yields rise, then the new price predicted by modified duration is understated in both cases. For example, if the yield on the 10-year, 5% bond
falls to 4%, modified duration predicts the price will rise to $107.79; the actual price, however, rises to $108.18. Similarly, if the yield rises to
6%, modified duration predicts the price will fall to $92.21; the actual price, however, falls to $92.56. In both cases, the new price predicted
by modified duration is less than the actual price.

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Figure 10.1 | Graphical Measure Of Duration And Actual Price-Yield Relationship

Actual bond price

Error
Price

Duration
approximation
of bond price Error

Yield

The straight line representing duration is at a tangent to the price-yield curve. Moving from the point at which the
two lines touch to any other point on the straight line provides an estimate of the new bond price for a given change
in yield. The new price can then be used to calculate a percentage price change.

For small changes in yield, the straight line is a good predictor of the bond price change because it is close to the
price-yield line. For larger changes in yield, however, estimates of the new price will be increasingly inaccurate.
Figure 10.1 confirms the following features of duration:
• As yields fall, prices rise by more than the amount predicted by the straight line. In other words, duration
underestimates the new price.
• As yields rise, prices fall by less than the amount predicted by the straight line. Again, duration underestimates
the new price.

We can improve, but not perfect, the duration calculation by adjusting for the convexity of the price-yield curve.
The tool used to do this is known as the bond’s convexity. Adding a convexity adjustment to the percentage price
change calculated using the duration calculation produces a much better estimate of the actual percentage price
change.
Given the bond’s convexity, Equation 10.7 can be used to calculate the approximate percentage change.
Convexity 2 (10.7)
Approximate Percentage Price Change Due to Convexity  q %y q 100
2

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 13

EXAMPLE
A 10-year, 5% semi-annual coupon bond has a modified duration of 7.80 when it yields 5%. The convexity of this
bond is 73.63. When the convexity is plugged into Equation 10.7 and added to the percentage price change due
to duration, the estimated percentage price change if the yield falls to 4.50% is found to be 3.99%.
Approximate Percentage Price Change = –7.80 × (–0.005) × 100 = 3.90%

73.63 2
Approximate Percentage Price Change Due to Convexity  q 0.005 q 100  0.09%
2

The two percentage changes are added together to get an estimate of the total percentage price change.
3.90% + 0.09% = 3.99%

From a starting price of $100, the estimated price at a yield of 4.50% would be $103.99. Checking against
Table 10.1, we find that this price is the same as the actual price at a yield of 4.50%.

Convexity will have the following properties for option-free bonds:

• The change in value resulting from the convexity term is always positive.
• Over a series of bonds with the same coupon rate and yield to maturity, convexity increases with time to
maturity.

The next section shows that debt securities with embedded options can occasionally have negative convexity, which
means that duration overstates the price of a debt security for a given change in yield.

PRICE VOLATILITY OF BONDS WITH EMBEDDED OPTIONS

A call or put option will affect a bond’s price-yield relationship. For a callable bond, at high yield levels, there is little
chance of the bond being called, therefore its price volatility characteristics will be similar to those of an otherwise
equivalent option-free bond. Below a certain yield level, however, the risk that the bond will be called rises. As
yields fall further, this probability rises, and the rise in price of the bond is limited by the potential call. Figure 10.2
illustrates this price behaviour.

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Figure 10.2 | Price-Yield Relationship of a Callable Bond

Non-Callable Bond
Callable Bond
Price

Yield

The horizontal portion for the callable bond shows the limitation in price appreciation and this limitation in price
appreciation means that a callable bond has negative convexity below a certain yield level. In other words, duration
overstates the new price of the bond for a given change in yield, and thus the correction to duration, the convexity,
must be negative to ensure that the estimated price of the bond for a given yield change is close to the actual price.

Similarly, for a putable bond, at low yield levels, there is little chance the investor will redeem the bond and it
will behave in the same manner as an option-free bond. As yields rise, however, there is a greater likelihood that
investors will redeem their bonds. This ability to redeem the bonds will limit the decline in the bond’s price as yields
rise further.

WHAT ARE DEBT SECURITIES STRATEGIES?

For debt securities, there are generally three broad strategy classifications:

Active strategies Are based on forming expectations and shifting assets around to take full advantage of
these expectations.

Passive strategies Generally lead to a portfolio that approximates a market index or is designed to reduce
the requirement to make decisions based on expectations.

Dedicated strategies Are designed to meet specific targets and goals.

When selecting debt securities, investment advisors must consider sector, maturity, credit quality, and embedded
options. Furthermore, each security’s pricing efficiency as well as the investor’s overall goals, risk tolerance, and
constraints must be considered in putting the portfolio assets together.
Diversification is an important component of asset selection. As with equities, as more debt securities are added to
a portfolio, diversification rises. Adequate diversification can be achieved with fewer than 25 bonds in a portfolio.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 15

Diversification requirements also depend on credit quality. It takes fewer issues to diversify a portfolio made up of
only high-quality issues than it does to diversify a lower-quality portfolio. This means that it takes fewer issues to
diversify a government bond portfolio than it does to diversify a corporate bond portfolio.
A common technique used in diversification is setting a maximum for the exposure to any single issuer of a certain
credit quality. Using a guideline of 20 corporate A-rated bonds for a conservative investor’s portfolio, the maximum
exposure to any single issuer would be no more than 5% of total bond holdings. This maximum exposure for any
other issue will therefore depend on both the investor’s tolerance and the credit quality of the bonds. As a general
guideline, a conservative investor should have no more than 3% in any BBB-rated issuer and would be excluded
from buying non-investment-grade debt, but this same investor could place as much as 10% in an AA-rated issuer.
An aggressive investor, meanwhile, would likely have a maximum 10% exposure to any BBB-rated issuer.
Table 10.7 provides a guideline for the maximum portfolio exposure to any single non-government issuer based on
the client’s stated risk tolerance.

Table 10.7 | Maximum Non-Government Exposures Based on Credit Rating and Risk Tolerance

Risk Tolerance AAA AA A BBB <BBB

Conservative 20% 10% 5% 3% 0%
Moderate 40% 20% 10% 5% 3%
Aggressive 100% 40% 20% 10% 5%
Speculative 100% 100% 50% 25% 10%

ACTIVE STRATEGIES FOR DEBT SECURITIES

Active strategies for debt securities generally fit into one or more of the following four categories:
• Interest rate strategies
• Yield curve strategies
• Intermarket spread strategies
• Intramarket spread strategies

ACTIVE STRATEGY 1: INTEREST RATE STRATEGIES

Active investors attempt to exploit differences between their own interest rate forecast and the forecast embedded
in market interest rates. By adjusting the duration of their debt securities portfolios, active investors endeavour to
take advantage of the changes in interest rates they expect.
Active investors who expect interest rates to rise will lower their overall portfolio duration; if they expect rates to
fall, they will increase the duration. The duration of a portfolio is changed by swapping bonds of different durations
into and out of a portfolio.

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10 • 16 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

EXAMPLE
An investor owns the following bonds in his portfolio:
Bond Market Value Modified Duration
A $150,000 3
B $100,000 5
C $100,000 10
D $150,000 15
Total $500,000 8.4

Suppose an investor expects the yield curve to fall evenly across all maturities, leading to higher bond prices.
If the yield to maturity on all bonds in the investor’s portfolio declines by 1 percentage point, the value of the
portfolio will increase by approximately 8.4%. To earn an even greater return, however, the investor can raise the
duration of the portfolio by selling some of the lower-duration bonds and buying some higher-duration bonds.
Suppose the investor decides to sell all holdings in Bond A and invest the proceeds in Bond D. After this
transaction, the investor’s portfolio will look like this:

Bond Market Value Modified Duration

B $100,000 5
C $100,000 10
D $300,000 15
Total $500,000 12

If interest rates fall as expected, the return on the new portfolio will be greater than the return on the original
portfolio. For instance, if the yield to maturity on all bonds declines by 1 percentage point, the value of the
portfolio will increase by approximately 12%.
The risk with this strategy is that if interest rates rise rather than fall, the return on the new portfolio will be less
than the return on the original portfolio. Given the need for liquidity in this type of strategy, government issues
are normally used.

Another active strategy involves riding the yield curve. If the yield curve is upward sloping and its shape and level
are expected to remain unchanged, an investor can buy a bond with a maturity much longer than the investment
horizon. The bond’s price will increase as yields fall down the yield curve with the passage of time.
To illustrate, consider five bonds each with an annual 6% coupon. In one year’s time, the current five-year bond will
be the market’s four-year bond, the current four-year bond will be next year’s three-year bond, and so on.

Maturity (years) Yield to Maturity (%) Current Bond Price Bond Price in 1 Year
1 3.90 102.021 100.00
2 4.50 102.809 102.021
3 4.90 103.00 102.809
4 5.25 102.64 103.00
5 5.60 101.70 102.64

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 17

If the investor has a one-year horizon, he has five strategies to choose from:
• Strategy 1: Buy the five-year bond and sell it one year later.
• Strategy 2: Buy the four-year bond and sell it one year later.
• Strategy 3: Buy the three-year bond and sell it one year later.
• Strategy 4: Buy the two-year bond and sell it one year later.
• Strategy 5: Buy the one-year bond and hold it to maturity.

The total return from the first strategy is [(102.64 + 6)/101.70] – 1 = 6.82%. The results from the other strategies are
summarized below.

Strategy 1 2 3 4 5
Total Return (%) 6.82 6.20 5.64 5.07 3.90

If rates had risen, strategy 1 would have returned less than 6.82% and possibly even less than strategy 5, buying the
one-year note. Generally, the steeper the curve at the start, the lower the interest rate when the bond is sold and
the higher the return on the strategy.
Active investors can also capitalize on their interest rate expectations using bonds with embedded options.
Understanding the negative convexity of certain issues allows investors to take advantage of the impact of interest
rate changes on the value of bonds with embedded options.
For example, suppose a five-year bond that is currently callable at par trades at a price of $100.50 with a yield of
6%. Five-year bonds are currently yielding 5%. If an investor believes that five-year yields are set to rise toward
6%, that investor would buy the callable bond that is already yielding 6% rather than nominal bonds that yield 5%,
since the fall in price of the callable bond would be less than that of the nominal bond.

ACTIVE STRATEGY 2: YIELD CURVE STRATEGIES

Two portfolios with the same duration will not necessarily perform in the same way when the yield curve shifts
in a non-parallel manner. Duration measures only price sensitivity under a parallel shift. Simply analyzing yield,
duration, and convexity will not provide an accurate estimate of portfolio performance over a specified time
horizon. Relative performance depends on both the magnitude of the change in yields and the type of yield curve
shift.
Yield curve strategies are designed by positioning bonds along the maturity spectrum to take advantage of expected
changes in the shape of the curve. For example, a portfolio with a specified duration can be built in one of two ways:

A bullet portfolio Has one or more bonds with roughly equal durations.

A barbell portfolio Has one or more bonds with short durations combined with one or more bonds with
long durations so that the average duration equals that of the bullet portfolio.

Although the portfolios will have roughly equal duration, they will have different degrees of convexity, which is key
to how they will respond to changes in the shape of the yield curve. Generally, barbell portfolios have the greatest
convexity and bullet portfolios the least. Which portfolio performs better will depend on changes in the shape of
the yield curve.

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The following example compares the performance of a bullet portfolio and a barbell portfolio using the bonds
shown in the table below.

Coupon and Yield Modified

Bond Term to Maturity Price to Maturity Duration Convexity
A 4%, 2 years 100.00 4.00% 1.90 4.62
B 6%, 5 years 100.00 6.00% 4.27 21.77
C 8%, 10 years 100.00 8.00% 6.80 60.17

The bullet portfolio contains $1,000,000 face value of Bond B, the five-year bond. The portfolio’s modified duration
and convexity are 4.27 and 21.77, respectively. The barbell portfolio contains $516,000 face value of Bond A, the
two-year bond, and $484,000 face value of Bond C, the 10 year bond. The portfolio’s modified duration and
convexity are 4.27 and 31.51, respectively. The portfolios have equal dollar value and modified duration, but not
convexity. The barbell portfolio has convexity of 31.51 versus a convexity of 21.77 for the bullet portfolio. Looking
ahead six months and examining the values of the two portfolios given specified changes in their yields helps
clarify how they behave when the yield curve shifts (note that in six months each of the bonds will make a coupon
payment that was included in the analysis).

PARALLEL YIELD CURVE SHIFTS

Figure 10.3 shows the values of the two portfolios when the yield curve shifts in a parallel manner.

Figure 10.3 | Bullet and Barbell Performance: Parallel Yield Curve Shifts

$1,150,000
Bullet
Barbell
$1,100,000

$1,050,000

$1,000,000

$950,000
-200 -150 -100 -50 -10 0 10 50 100 150 200

Based on this analysis, the barbell portfolio outperforms the bullet portfolio when the parallel shift is significantly
large, especially for downward shifts, because it benefits from its greater convexity. For small parallel shifts, the
greater convexity of the barbell portfolio is not enough to offset the bullet portfolio’s yield advantage.

Table 10.8 shows the values of the two portfolios when the yield curve shifts in a parallel manner.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 19

Table 10.8 | Bullet and Barbell Performance – Parallel Yield Curve Shifts

Price Plus Coupon Portfolio Values

Yield Change Outperforming

(In Basis Points) Bond A Bond B Bond C Bullet Barbell Portfolio

-200 104.9410 111.1622 118.3238 $1,111,622 $1,114,183 Barbell

-150 104.1949 109.0493 114.5089 $1,090,493 $1,091,869 Barbell
-100 103.4561 106.9854 110.8549 $1,069,854 $1,070,371 Barbell
-50 102.7245 104.9694 107.3543 $1,049.694 $1,049,653 Bullet
-10 102.1443 103.3902 104.6595 $1,033,902 $1,033,617 Bullet
0 102.0000 103.0000 104.0000 $1,030,000 $1,029,680 Bullet
10 101.8559 102.6116 103.3461 $1,026,116 $1,025,772 Bullet
50 101.2825 101.0760 100.7852 $1,010,760 $1,010,418 Bullet
100 100.5720 99.1962 97.7034 $991,962 $991,836 Bullet
150 99.8683 97.3594 94.7485 $973,594 $973,903 Barbell
200 99.1714 95.5647 91.9147 $955,647 $956,591 Barbell

NON-PARALLEL YIELD CURVE SHIFTS

We can do a similar analysis on non-parallel shifts in the yield curve. For example, suppose that the yield curve
steepens. Given an upward sloping yield curve, short-term yields decline relative to long-term rates. Figure 10.4
assumes that the yield change on the two-year bond is the yield change on the five-year bond minus 50 basis points,
while the yield change on the 10-year bond is the yield change on the five-year bond plus 50 basis points.

Figure 10.4 | Bullet and Barbell Performance: Steepening Yield Curve Shifts

$1,150,000
Bullet
Barbell
$1,100,000

$1,050,000

$1,000,000

$950,000

$900,000
-200 -150 -100 -50 -10 0 10 50 100 150 200

When the yield curve steepens, the bullet portfolio outperforms the barbell portfolio in all scenarios.

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10 • 20 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

Now assume that instead of steepening, the yield curve flattens. Figure 10.5 assumes that the yield change on the
two-year bond is equal to the yield change on the five-year bond plus 50 basis points, while the yield change on the
10-year bond is equal to the yield change on the five-year bond minus 50 basis points.

Figure 10.5 | Bullet and Barbell Performance: Flattening Yield Curve Shifts

$1,150,000
Bullet
Barbell
$1,100,000

$1,050,000

$1,000,000

$950,000
-200 -150 -100 -50 -10 0 10 50 100 150 200

When the yield curve flattens, the barbell portfolio outperforms the bullet portfolio in all scenarios.

When the yield curve shifts in a non-parallel manner, a portfolio’s modified duration and convexity are inaccurate
measures of performance because their definitions implicitly assume parallel shifts in the yield curve.5 In these
situations, the impact of individual bonds has a more prominent role. In our analysis, the long-term bond had the
biggest impact on the relative performance of the bullet and barbell portfolios.

ACTIVE STRATEGY 3: INTERMARKET SPREAD STRATEGIES

Intermarket spread strategies involve attempting to capitalize on the difference in yield spreads and expected
changes in yield spreads between different sectors of the bond market.
Credit spreads offer the immediate advantage of higher yields. Therefore, over time, corporate and provincial bonds,
which trade at higher yields to Canada bonds, should outperform Canada bonds. Historically, this has been the case;
however, credit spreads tend to widen during economic downturns and narrow during periods of economic growth.
Furthermore, credit spreads represent the market-assessed risk of the potential for default.
Active investors often attempt to anticipate changes in the direction of credit spreads and take advantage of their
expectations by modifying their exposure to each sector of the market based on this anticipation. In doing so, they
take the relative duration into account, incorporating interest-rate and yield-curve strategies in inter-market spread
strategies when evaluating swaps between market sectors.

EXAMPLE
Suppose an investor anticipates a period of strong growth over the next year, exceeding consensus market
expectations. The investor should consider switching out of, say, two-year Canada bonds and into two-year
corporate bond issues, taking advantage of the expected contraction in spreads normally associated with periods
of economic growth.

5
Academics and analysts have developed more sophisticated measures of duration and convexity that more accurately describe the expected
performance of a bond or bond portfolio when the yield curve shifts in a non-parallel manner.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 21

ACTIVE STRATEGY 4: INTRAMARKET SPREAD STRATEGIES

Intramarket spread strategies, also known as substitution swaps, involve swapping bonds that are largely similar.
The investor may have identified mis-priced securities or may see relative value differences between two bonds
from two different issuers in the same business sector.
For example, a Canadian investor might see better prospects for the Bank of Nova Scotia over the next year
compared with TD Bank and expect a small improvement in the Bank of Nova Scotia’s credit ratings as a result. The
investor would then sell five-year TD Bank bonds and buy five-year Bank of Nova Scotia bonds that are currently
trading with the same yield.
This strategy can also be applied to swapping securities of the same issuer. For example, an investor might switch
from senior secured debentures to subordinated debentures for the additional yield provided by the more junior
security.
Finally, Canadian investors with core holdings in each sector may leave assets in higher-yielding, less liquid
securities. For example, an investor could invest in higher-yielding federal agency/Crown corporation bonds rather
than more liquid Government of Canada issues.

PASSIVE STRATEGIES FOR DEBT SECURITIES

There are two main forms of passive strategies using debt securities: indexation and laddering.

PASSIVE STRATEGY 1: INDEXATION

An indexed portfolio is designed to track the performance of a specific market index. In selecting the appropriate
index for a portfolio, investment advisors must take into account the investor’s risk tolerance and objectives, as
well as regulatory constraints. Some indexes have exposure to market segments that do not match the investor’s
risk tolerance. Therefore, the index chosen must be appropriate to the investor’s total return expectations and not
conflict with any investment selection constraints.

CANADIAN BOND INDEXES

In Canada, investment dealers can track the FTSE TMX Canada Universe Bond Index. A further breakdown of this
index is shown by sector, term to maturity, and credit quality.

INDEX CONSTRUCTION METHODS

Investors can index their bond holdings either through a bond index mutual fund or by purchasing all the issues in
the index. But this is an inefficient method of reconstruction given that the widely followed benchmark in Canada,
the FTSE TMX Canada Universe Bond Index, consists of over one thousand bonds and many of these bonds are
thinly traded. Market impact is a major issue because indexes regularly change composition as bonds mature.
Instead, investors can use a sampling procedure to select certain issues, the combined characteristics of which
represent the characteristics of the benchmark index. The goal of the sampling procedure is to eliminate any unique
or unsystematic risk associated with any individual security.
There are two common sampling procedures to replicate an indexed portfolio: the stratified sampling or cell
approach, and the optimization approach.

1. STRATIFIED SAMPLING OR CELL APPROACH

The stratified sampling approach takes a market index and divides it into parts, or cells, that represent a cross-
section of different portfolio characteristics, such as duration, coupon, maturity, sector, credit rating, and call
features.
For example, suppose an investor wishes to replicate an index across three characteristics (duration, coupon, and
maturity). Each characteristic is subdivided into smaller classifications, and the number of subdivisions under
each characteristic is multiplied together to arrive at the total number of cells. Maturity could be subdivided into

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10 • 22 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

three classifications (less than 5 years, 5 to 10 years, and more than 10 years). Likewise, duration could have two
classifications (10 years or less and more than 10 years) and coupon could have three classifications. The total
number of cells would be 18 (3 u 2 u 3).
The goal is to choose securities that best represent the characteristics of an entire cell. The share of dollars invested
in each cell depends on that cell’s proportionate share of the entire universe. The number of cells dividing up the
index will depend on the dollar amount of the tracking portfolio. The fewer the dollars a portfolio has to invest, the
fewer cells will be employed to minimize tracking error from transaction costs.

2. OPTIMIZATION APPROACH
The optimization approach builds on the stratified sampling approach by using mathematical programming to
optimize the portfolio based on the stated return objectives and constraints.
Stratified sampling is the easier of the two methods but it is very difficult to put into practice with diversified
benchmarks that have a large number of bonds. Many cells would be required and, because the matching of bonds
to each cell is a subjective process, tracking error may result. To reduce tracking error, the optimization approach can
be used. Tracking error represents the difference between portfolio performance and the return on the benchmark
portfolio. It occurs because of transaction costs, reinvestment, differences in portfolio composition, and differences
in prices between those used to calculate the index (closing bid prices) and the prices actually paid or received by
the investor.
Indexation is more successful, or tracking error is lower, for government indexes than for corporate indexes. The
corporate sector is problematic for indexed investors because of its lower liquidity, lack of transparency, and larger
bid-offer spreads.

PASSIVE STRATEGY 2: LADDERING

The laddered bond approach is a passive strategy that takes away much of the decision-making process and instead
forces discipline on bond investment and selection. Laddering involves building a portfolio of debt securities with
staggered maturities so that a portion of the portfolio matures at regular intervals. The portfolio is normally
structured so that an equal dollar portion of the portfolio is placed in each maturity interval.
To maintain the ladder, as debt securities mature, the maturity amount is re-invested at the long-term end of the
ladder, often at higher interest rates given an upward-sloping yield curve. Over time, the portfolio comes to include
only debt instruments that were originally purchased at the longest allowable maturity date. Purchases are made in
all interest rate cycles, regardless of expectations, with the idea that over time this will even out overall returns.
The goal of the laddered portfolio is to achieve a consistent return over all interest-rate cycles that compares
favourably with the return on the longest-term debt instrument available. Generally, this approach is used for
income-oriented portfolios, as the ladder provides a good indication of future cash flow, the income stream remains
relatively constant, and only a small portion of the portfolio is re-invested every year.
Laddering is a buy-and-hold strategy that allows for increasing exposure to less liquid sectors such as provincial and
corporate bonds. Laddering can incorporate limited active decisions during periodic re-investment, such as inter-
and intra- market trades. However, it is important to maintain balance within the laddered structure in terms of
sector exposure and to be aware of proper diversification principles. Laddered bond portfolios are often structured
with just one debt security in each maturity period, and therefore may be biased toward better-quality issuers.

DEDICATED STRATEGIES
Dedicated strategies entail building bond portfolios or portions of bond portfolios to meet future cash flow
needs, such as planned future expenditures. These strategies are based on the amount and timing of the future
expenditures and the funds currently available to meet the expenditures.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 23

There are three different types of dedicated strategies: cash-flow matching, immunization, and contingent
immunization. Immunization and contingent immunization are typically used by institutional investors, so they are
not discussed any further in this course (for more on these strategies, see CSI’s Portfolio Management Techniques
course). Cash-flow matching, however, is a popular and useful strategy for any investor with a future cash flow
need.
For a single future cash need, the simplest method is to set aside funds today and invest them in a zero-coupon or
strip coupon with a maturity date and maturity value equal to those of the liability. For example, an investor may
want to buy a $200,000 vacation property in two years’ time. The money is available now, and the investor needs
to set it aside specifically for that date. The investor could therefore buy a strip coupon with a face value equal to
$200,000 and a maturity just before the intended purchase date.
For a multiple liability stream, a bond is selected with a maturity equal to that of the last liability. The amount
of principal in this bond is equal to the amount of the last liability. The coupon payments of the bond reduce the
remaining components of the liability stream and a new bond is chosen to match the new (and just reduced) next-
to-last liability. This process is repeated until all liabilities have been matched.
With cash flow matching, there are no duration or performance requirements. Also, no rebalancing is required since
all cash flows have been matched with investments today. Lastly, there is no risk that the liabilities will not be met,
assuming there are no defaults.

INTERNATIONAL INVESTING
Investing in debt securities outside the domestic market helps to diversify a portfolio by increasing the number of
available investments to choose from and measure against, as well as by taking advantage of different economic
cycles. As the world economy becomes more intertwined, the global business cycle has a much greater impact
on domestic business cycles than ever before. However, every nation has a unique economic character, with its
own industry strengths, natural resources, and approaches to monetary policy and financial market management.
Therefore, some differences in business cycles and investment opportunities remain between nations, which
portfolio managers can use to enhance total portfolio returns.
Bond markets in general trade on a currency basis because assets denominated in one currency are more easily
evaluated against other assets in the same currency. For example, all U.S.-dollar-denominated debt securities trade
in relation to the U.S. Treasury market, just as all Canadian-dollar-denominated debt securities trade in relation
to the Government of Canada market. Furthermore, the value of a currency is based both on the current domestic
economic situation (including the relative level of interest rates and inflation) and future growth expectations.
When evaluating any foreign currency investment, it is important to build in future expectations for changes in the
relative value of exchange rates.
Given the close ties between countries with well-developed financial markets, bond markets tend to move
somewhat in tandem. Several trading blocs have historically been more closely related to each other than to
markets in other trading blocs. The following are bond market blocs:
• The Dollar Bloc consists of the United States, Canada, Australia, and New Zealand. The U.S. market, the largest
bond market in the world, tends to influence other bond markets, especially the Canadian market, given the
close trading ties between the two nations. Although Australia and New Zealand are not as closely linked by
trade, their economies are similar to Canada’s in many respects, being open and resource-based, and there are
also political and cultural similarities. International bond portfolio managers generally view the United States
as a core market and consider allocations to Canada, Australia, and New Zealand on a relative-value basis.
Therefore, barring significant differences in domestic economies, the Canadian, Australian, and New Zealand
markets often trade in close relation to one another.
• The Eurozone trading bloc consists of the member states in the European Union that adopted the euro as a
currency. All new debt issues in these nations are denominated in euros, and their economies share the same

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central bank, hence they trade in close relation to one another. The benchmark yield curve in the Eurozone is
the German “bund” curve because Germany continues to represent the largest economy in the area. Other
government debt generally trades in close relation to the German bund based on relative credit quality and
liquidity. Corporate debt is normally benchmarked against the bund as well.
• Periphery Europe includes the nations that make up the balance of Western Europe, which also have significant
debt markets. Despite geographical proximity and economic ties, given the size of these markets and their
independent economic situation, their trading is separate from the larger Eurozone bloc. The independent
monetary policies of these countries are a significant factor in determining economic and bond market
performance compared with that of the Eurozone.
• The Japanese bond market is the second-largest bond market in the world. The export-driven Japanese economy
has close ties to the world economy, but the Japanese market is dominated by domestic banking and internal
political issues, and generally trades somewhat separately from other major bond markets.
• Emerging Markets includes developing nations, which usually do not have significant domestic debt markets;
rather, these nations seek to raise capital in global financial markets by issuing debt instruments in U.S. dollars,
euros, or yen. The debt instruments of developing nations are often not investment grade, and therefore
this market represents a speculative asset class. Although governments generally do not default, they do
restructure, and this has occurred to the great expense of investors.

Investors may decide to invest outside the domestic debt market for a number of different reasons. Often,
international investing is considered a more active approach, and the decision is normally based on expectations
of improving total return, both from an interest rate and currency perspective. However, investors can also include
international bonds in a larger investment strategy. For example, an investor could add some foreign currency
exposure as one rung of a laddered portfolio.
Most Canadian individual investors gain exposure to international bond markets by buying a managed product
such as a mutual fund. Managed products offer instant diversification and professional management at a lower cost
than direct investment in individual bonds. Investors can choose from a large number of funds, including American,
European, and Asian bond funds, as well as global funds that invest in multiple regions.

EVALUATING THE DIFFERENT MANAGEMENT TECHNIQUES

Debt security portfolio management has undergone significant change over the past several decades, evolving
along with debt instruments themselves, as different management techniques have been evaluated and have
become better understood. One relationship that has been consistently proven is the negative relationship between
management expenses and net returns. Management expenses are a direct loss to the investor. Not only do they
reduce returns, but the higher the expenses charged, generally the lower the net return.
In evaluating funds with the same management style, lower-cost funds have consistently outperformed higher-
cost funds for many different investment horizons. Furthermore, the relationship becomes stronger the longer
the horizon. This is consistent with the view that markets are efficient, which suggests a more passive, low-cost,
indexation approach. However, indexation is not necessarily the appropriate investment style for every investor
given differences in return objectives, risk tolerances, and constraints. Empirical studies on the success of different
management styles before management fees are deducted have been less conclusive. Portfolio managers have
proven they can add value and increase returns by reducing credit quality, extending duration, sacrificing liquidity, or
adding securities from outside the domestic debt market. This has led to the development of “core-plus” strategies,
such as the combination of a “core” indexed portfolio component along with several active (“plus”) management
ideas.
Nonetheless, in ever-changing debt markets, building on the individual investor’s criteria is the most important
factor in determining the appropriate management style. Portfolio managers need to build expertise in a breadth of
products to fulfill return objectives under varying constraints. The future will likely bring even more changes to debt
markets, requiring portfolio managers to adapt in order to succeed.

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 CHAPTER 10 | ANALYSIS OF DEBT SECURITIES II: PRICE VOLATILITY AND INVESTMENT STRATEGIES 10 • 25

SUMMARY
By the end of this chapter, you will be able to:
1. Calculate and explain the relationship between bond prices, duration, and convexity.
• A basic property of all option-free bonds is that bond yields are inversely related to bond prices.
• Bond price volatility can be measured by the absolute dollar change or the percentage change in the bond
price for a given change in yield.
• The volatility of bond prices, as measured by instantaneous percentage price changes, depends primarily
on two of the bond’s features: the coupon rate and the term to maturity. The measure which combines the
impact of both the coupon rate and the term to maturity is known as duration.
• A bond’s Macaulay duration is the weighted-average term to maturity of the present value of a bond’s interest
and principal payments.
• A bond’s modified duration is a measure of the approximate percentage price change for a 100-basis-point
change in yield.
Macaulay Duration
Modified Duration 
1 y k

• Adding a convexity adjustment to the percentage price change calculated using the duration calculation
produces a much better estimate of the actual percentage price change.

2. Calculate bond price changes due to duration or convexity.

• Modified duration can be used to calculate an approximate percentage price change of a bond:
Approximate Percentage Price Change = –Modified Duration × Δ y × 100

• The formula to find the approximate dollar change is:

Approximate Dollar Change = –Modified Duration × Δ y × MV

• The approximate percentage price change due to convexity is:

Convexity 2
Approximate Percentage Price Change Due to Convexity  q %y q 100
2

3. Choose debt strategies that respond to appropriate objectives to create bond portfolios.
• Active strategies are based on forming expectations and shifting assets around to take full advantage of
these expectations. Active strategies for debt securities generally fit into one or more of the following four
categories:
« Interest rate strategies
« Yield curve strategies
« Intermarket spread strategies
« Intramarket spread strategies
• Passive strategies generally lead to a portfolio that approximates a market index or is designed to reduce the
requirement to make decisions based on expectations. There are two main forms of passive strategies using
debt securities:
« Indexation
« Laddering

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10 • 26 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 5

• Dedicated strategies are designed to meet specific targets and goals. There are three different types of
dedicated strategies:
« Cash-flow matching
« Immunization
« Contingent immunization

© CANADIAN SECURITIES INSTITUTE (2017)

 SECTION 6

MANAGED PRODUCTS

11 Analysis of Conventionally Managed Products

Analysis of Non-Conventional Asset Classes and
12
their Structures
13 Insurance-Based Investment Products

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 Analysis of Conventionally
Managed Products 11

CONTENT AREAS

What Is a Conventionally Managed Product?

What Is the Role of Conventionally Managed Products in Investment Management?

What Are Mutual Funds?

What Are Closed-End Funds?

What Are Wrap Products?

What Is Overlay Management?

What Are Fees and Turnover?

What Is the Relationship Between Taxes and Returns on Conventionally Managed Products?

LEARNING OBJECTIVES

1 | Explain the role of conventionally managed products in a portfolio.

2 | Explain the relative suitability of mutual fund investments.

3 | Describe the features of various managed products.

4 | Explain overlay management.

5 | Advise a client of advantages and disadvantages of overlay management.

6 | List the various techniques through which to obtain overlay management.

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 CHAPTER 11 | ANALYSIS OF CONVENTIONALLY MANAGED PRODUCTS 11 • 3

INTRODUCTION
Conventionally managed products have been popular investment vehicles for many investors, particularly those
that consider direct investing in bonds or equities too complex or risky. They are often appropriate for investors
who have a limited amount of money to invest but want the benefits of diversification and professional investment
management.
A variety of conventionally managed products are available to investors. This chapter provides guidance for
investment advisors to help their clients find the right conventionally managed products for their situation.
The chapter begins with a definition of conventionally managed products and then discusses the role of managed
products in investment management. A review of mutual funds follows. The chapter continues with an overview of
closed-end funds and wrap products, introduces overlay management, and concludes with a discussion of the effect
of fees, turnover, and taxes on the performance of managed products.

WHAT IS A CONVENTIONALLY MANAGED PRODUCT?

A conventionally managed product is a pool of capital gathered to invest in a portfolio of other securities according
to a specific investment mandate. A management fee is paid to a professional money manager to carry out this
mandate. A conventionally managed product is a long-only vehicle, holding just equities, bonds or cash.
Conventionally managed products can be managed actively or passively:
• The manager of an actively managed fund makes investment decisions based on his outlook for the markets
and securities in which he invests, both of which should be clearly identified in the fund’s investment mandate.
In almost all cases, active fund managers intend to outperform the return on a specific benchmark index.
• The manager of a passively managed fund does not make security selections based on his outlook. The
manager accepts only the systematic risk associated with investing in a particular asset class. The most
common type of passively managed fund is one that attempts to replicate the returns on a market index.

WHAT IS THE ROLE OF CONVENTIONALLY MANAGED PRODUCTS

IN INVESTMENT MANAGEMENT?
The overall use of conventionally managed products varies among investment advisors. Some advisors rely
exclusively on managed products to create client portfolios, others use them to form part of their clients’ portfolios,
and some do not use them at all. Is there a “correct” mix of managed products and individual securities in a client’s
portfolio?
The choice of whether and how extensively to use managed products depends on the client’s needs.
The size of the client’s portfolio and the need for diversification are also considerations. A client with a relatively
small portfolio may not be able to buy enough individual securities to achieve an adequate level of diversification.
Managed products allow for diversification in a small portfolio.
Transactions costs are another consideration. Bid-ask spreads on individual securities such as bonds can be large
for trades of smaller amounts. This is a disadvantage to a client attempting to enter a particular market with only
a small amount to invest. High transaction costs on individual securities also make certain types of managed
products, especially mutual funds, an ideal investment for clients looking to invest money on a regular basis.
For clients who want to invest in individual securities outside Canada and the United States, it may be difficult to
find a broker who can carry out trades in a foreign country and to get adequate information about foreign securities.
For these clients, managed products may offer a solution.

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Managed products can be purchased in any variety or combination of asset classes or risk levels. But traditionally
the most common form of managed products used by investors have been mutual funds.

WHAT ARE MUTUAL FUNDS?

A mutual fund is an open-ended investment company that is structured either as a corporation or as a trust and
that raises capital by issuing shares (in the case of a mutual fund corporation) or units (in the case of a mutual fund
trust).1 The capital is used to purchase securities according to the fund’s investment mandate.
Mutual funds are in a continuous state of distribution: investors can buy the fund’s units from or sell (redeem) the
fund’s units to the fund itself during any business day on which the Canadian markets are open for trading. At the
time the order is entered, however, the investor does not know the price at which the transaction will occur; the
price is determined after the Canadian markets have closed.
The classification of mutual funds in Canada is carried out by the Canadian Investment Funds Standards Committee
(CIFSC),2 which comprises Canada’s major mutual fund database and research firms. As there are no industry-
standardized categories for mutual funds in Canada, the CIFSC has a self-imposed mandate to standardize the
classifications of Canadian-domiciled mutual funds. The CIFSC lists various categories for Canadian-domiciled
mutual funds.

THE MUTUAL FUND ORGANIZATION: TRUST STRUCTURE

THE TRUST STRUCTURE
Most mutual funds are organized as a trust. Funds organized under a trust structure pay out any income remaining
from investment activity to the fund’s unitholders of record on a specific date after deducting the fund’s expenses.
If this income remained undistributed, the trust would have to pay tax at the top marginal rate. Less tax will be paid
overall if the fund distributes all of its income to unitholders, who are generally taxed at a lower marginal rate than
the trust. Sometimes the trust structure results in an untimely tax liability.
Consider a fund that is created on January 1 with a $10,000 purchase of units by its first investor. Also assume
that at the beginning of each month a new investor buys $10,000 worth of units and that the fund appreciates
1% in each month except for the last month when it loses 1%. At the end of 10 months the fund has 10 investors
who have contributed a total of $100,000 and have 9,566.03 units. The fund has a net asset value per share of
$10.8275 and a total value of $103,576.19 (10.8275 u 9,566.03 units). The fund has increased in value by $3,576.19
($103,576.19 – $100,000). On November 1, assuming the increase is fund value consists of realized capital gains,
the fund will make a capital gains distribution on all of the profits. As there are 9,566.03 units, the capital gains
distribution is $0.3738 per unit.

1
For the sake of brevity, only the term units is used for the remainder of this chapter.
2
For more information, the CIFSC’s website is www.cifsc.org

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 CHAPTER 11 | ANALYSIS OF CONVENTIONALLY MANAGED PRODUCTS 11 • 5

Table 11.1 | Profit (Loss) Versus Capital Gains Distributions

Holding Dollar Market Profit Capital Gains

Investor Period Investment Units Value (Loss) Distribution
1 10 months $10,000 1,000.0 $10,827.50 $827.50 $373.80
2 9 months $10,000 990.10 $10,720.31 $720.31 $370.10
3 8 months $10,000 980.30 $10,614.20 $614.20 $366.44
4 7 months $10,000 970.59 $10,509.06 $509.06 $362.81
5 6 months $10,000 960.98 $10,405.01 $405.01 $359.21
6 5 months $10,000 951.47 $10,302.04 $302.04 $355.66
7 4 months $10,000 942.05 $10,200.05 $200.05 $352.14
8 3 months $10,000 932.72 $10,099.03 $99.03 $348.65
9 2 months $10,000 923.48 $9,998.98 ($1.02) $345.20
10 1 month $10,000 914.34 $9,900.02 ($99.98) $341.78

In Table 11.1, note the differences between the Profit (Loss) and Capital Gains Distribution columns. Investor 1 made
over $827 in profit but has to pay capital gains taxes on only $373.80. Investor 10 unfortunately has to pay taxes
on $341.78 of capital gains in spite of an actual loss of $99.98. In fact, investors 6 to 10 have taxable distributions
greater than their actual profit/loss, which amounts to a prepayment of taxes. The example is not unusual in the
real world where investors typically make lump purchases over many years and sometimes find themselves with
unwanted and unwarranted tax liabilities.

DUE DILIGENCE AND CONSIDERATIONS FOR INVESTMENT SELECTION

Given the choice of thousands of different types of mutual funds, how does an investor select appropriate funds and
create a portfolio? The decision is not simple and involves 1) performing due diligence to be certain the fund and
fund company are viable businesses and 2) considering various factors to be sure that the investment is correct for
the investor.

DUE DILIGENCE
Buying a mutual fund means devoting oneself to a business relationship with the management firm. Assuming a
risk assessment is completed and an asset allocation is in place, an investor must consider five elements of mutual
funds before selecting suitable candidates: personnel, business, philosophy, process, and performance.

PERSONNEL
Ideally, a fund should be headed by a portfolio manager with several years’ experience and backed by a team of
analysts, client service staff, back office staff, and technology. An ideal organization should have strong, stable
ownership and be well capitalized to fund future growth. The portfolio managers should have an equity stake in the
firm, with performance bonus incentives.
Evaluation of the portfolio manager and the investment team might be the most important part of the mutual fund
assessment process. Without a good portfolio manager leading a competent investment team, all other factors
become unnecessary. Portfolio managers should have spent several years successfully managing money in their area
of specialization, long enough to encompass at least the ups and downs of one market cycle (generally five years or
more). Also, it is helpful if their experience matches the investment specialization the fund client desires. Managers
ideally spent their early professional years at firms or with individuals that are well respected in the business.

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Managers should have some years of experience working with their investment team, whether with the present or
a former employer. Group dynamics take time to work out and may detract from investment performance if they
are not settled; thus staff turnover should be low, especially at key positions. Low staff turnover may imply the
firm is spending its energies on client portfolios, is unified in its business strategy, and has good morale within its
ranks. Portfolio managers should be able to focus largely on investment management; however, managers are also
responsible for a broad range of duties beyond investment research. There are ethical and regulatory compliance
requirements, a broad range of business issues, plus client service, marketing, and sales. Good investment
management firms have enough resources to address these needs; thus their investment professionals can focus on
portfolio management.
Strong and stable ownership supplies the leadership necessary to grow the business and keep employees motivated.
Strong ownership provides staff with all the tools they need and sets the tone for culture and morale. It also
creates an atmosphere of certainty that keeps the firm focused on providing the best investment analysis possible.
Favourable ownership structures exhibit some of the following qualities:
• The firm has a large majority or 100% employee ownership, because the interests of the firm become aligned
with the interests of the principal owners. The lesser the extent of outside ownership, the smaller the chance of
intervention in the decision-making process.
• Current ownership should have the authority to grant equity in the firm to attract and retain talented staff. If
equity is made available as personnel leave the firm through retirement, termination or attrition, or if minority
stakeholders choose to divest, the remaining employees should have the first chance to buy the shares.
• Succession planning is in place to ensure a seamless transition if a principal of the company retires or passes
away. The loss of one or two key individuals can cripple a firm’s investment ability.

BUSINESS
The business should finance day-to-day operations, including overhead, technological infrastructure, and salaries
plus bonuses and profit sharing. Steady growth in clients and assets under management (AUM) is a good sign, but
there is no formula. If a critical mass test is not met, there will be indirect signs such as high staff turnover.
It is also important that the client and product lists be diversified. If there are primarily large clients and one takes
its assets out of the firm, there could be significant damage to the fund. Also, given the cyclical nature of the
investment industry, where one moment small stocks are in favour then value stocks, it is prudent business practice
to have a broad product base.
A plausible business plan for growth accounts for inevitable attrition in clients and personnel and a need to
constantly improve service and technology. Business plans should also balance the need for growth with the
availability of capital and demands on executive staff. If plans are too ambitious, they will distract management’s
attention. Also, the need for significant capital may introduce outside owners that have interests that are not
necessarily aligned with those of the firm.
To ensure that staff goals are in line with investor goals, proper compensation plans need to be in effect. If profit
sharing is not available to all employees, there should be well-structured performance incentives. Bonuses for
investment managers should be based on performance, aligning their interests with those of investors, and ideally
managers should be required to invest their personal money alongside that of their clients. Studies have shown
managers are more likely to outperform benchmarks when pay is closely linked to performance. One study3
concluded that, on average, incentive-fee funds returned 1% more per year than similar funds without these fees,
though with slightly more risk. Another study4 suggested that managers are more likely to beat the benchmark
if they also exceed certain performance hurdles. On the other hand, those paid a declining percentage of assets
under management had the least incentive for good performance, which was reflected in returns. Managers whose

3
Edwin J. Elton, Martin J. Gruber and Christopher Blake, Incentive Fees and Mutual Funds, Journal of Finance, April 2003, Vol. 58, pp.779–804.
4
Finance Department, INSEAD, Compensation and Managerial Herding: Evidence from the Mutual Fund Industry, November 2005.

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compensation was a flat percentage of assets under management generally fell in the middle of performance
rankings.
Superior investment management organizations possess internal checks and balances against high closing, front
running, and other conflicts of interest. The integrity of the manager reflects on the quality of the firm, and the cost
of poor compliance is lost trust and loss of clients. Good compliance practice extends to all aspects of the business.
Compliance should be the domain of a non-investment officer, and all trades made by the firm should be frequently
and regularly audited. Trades made by the portfolio managers should be routed through the firm’s trading desk.
Managers should not conduct trades for their own account, for their spouse, or for immediate family. All significant
investment staff should sign a disclosure statement of personal holdings. Investment firms have different
philosophies on personal trading. Some feel that professional staff should be prohibited from any ownership of
securities except through mutual funds. If a firm does allow personal trading, it should be pre-cleared through either
the trading desk or the compliance officer.

PHILOSOPHY
An investment philosophy is a coherent way of thinking about how markets work and how they might be incorrectly
priced. There are several philosophies co-existing in the market place, any one of which could be correct at any
one time. There is no right or wrong philosophy. Superior investment firms should clearly and cleanly articulate
their investment philosophy. The more clearly they can explain it, the more likely they will be able to execute it
consistently and successfully, and the better an investor can harmonize their philosophy and risk tolerance to that
of the investment firm.
Equity and fixed-income investment philosophies can each be classified into distinct styles. The following strategies
are used in equity investing:
• Value investing promotes a conservative approach to money management. Value investors want to buy a firm
for less than what the assets in place are worth. They avoid paying the large premiums for growth companies
and seek bargains in mature companies that are out of favour. Value investors have a better chance of
succeeding if given a long time horizon (at least five years).
• Growth investors are more concerned about the future prospects of a firm than its present price. A firm might be
trading for more than its intrinsic value, but growing earnings will increase the intrinsic value beyond its current
price. Proponents of growth investing seek companies in sectors entering a period of expanding earnings.
Growth sectors have certain qualities, such as limited competition, high-quality research and development
programs, relatively low labour costs, and strong returns on invested capital. Growth investors usually make an
estimate of earnings growth, buying either on high expected future earnings growth rates or on high historical
earnings growth rates.
• Sector rotation is based on the belief that different industries of the economy will perform well during certain
stages of the economic cycle. Sector rotation is a portfolio manager’s attempt to profit through timing.
Industries expected to outperform would be overweighted in portfolios. More emphasis is placed on industry
weighting than on security selection.
• Proponents of momentum investing believe that strong gains in earnings or stock price will translate into
stronger future gains in earnings or stock price. Momentum managers typically employ technical or quantitative
stock selection models that also use some fundamental variables to smooth out the volatile nature of the style.
It is a high-risk, high-return strategy. Momentum portfolios typically have high turnover rates as failing stocks
are sold. Portfolios also tend to be more concentrated in certain areas of the economy than other funds.
• Growth at a reasonable price (GARP) is basically a value approach to buying earnings growth. GARP managers,
like growth managers, seek companies with projections of growing earnings and high and increasing returns on
equity relative to the industry average. Unlike growth managers, GARP investors avoid stocks with high P/Es and
P/Bs. In addition, GARP managers use a yardstick called a PEG ratio, which is the P/E divided by earnings growth.
A PEG less than one implies that the stock price is less than it should be given its earnings growth and warrants
closer attention; a PEG greater than one implies the stock is overpriced relative to its growth prospects.

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The following strategies are used in fixed-income investing:

• A basic interest rate anticipation strategy moves between long-term government bonds and very short-term
Treasury bills based on a forecast for interest rates over a certain time horizon. A manager might use bonds of
varying maturity depending on his confidence in the forecast. The main drivers of the forecast are central bank
monetary policy at the short end and inflation expectations at the long end. Price sensitivity to interest rate
movements increases as the term to maturity increases and the coupon decreases.
• Value or security selection for bonds involves fundamental and credit analysis and quantitative valuation
techniques of individual securities. Fundamental analysis of a bond considers the nature of the security and its
potential cash flow. Credit analysis evaluates the likelihood that the payments will be received as contracted,
if at all, and considers industry conditions, the economy, and other macroeconomic factors, as well as factors
specific to the issuer.
• Sector trading strategies vary the weights of different types of bonds held within a portfolio. An investment
manager will form an opinion on the valuation of a specific sector of the bond market based on its credit,
fundamental, and relative valuations compared to historical norms and technical factors, such as supply and
demand. A manager usually compares the portfolio to the weightings of the benchmark index for performance
assessment.
• High-yield investors are willing to assume interest rate risk to increase return by holding high-yielding securities.
High-yield strategies are not pursued in response to mispricing but are an attempt to earn extra income.

PROCESS
If philosophy is the belief system on which assets are valued, process is the methodology by which value is accrued
to the fund. No one process at any time can be said to be superior to another, but good investment organizations
should have two outstanding qualities of process:
• Elements that are verifiable and transparent
• Decision-making procedures that are team based

Process elements are the factors used and the way they are co-ordinated to value assets, and they should be
grounded in financial or economic theory. They can include records of company visits and manager interviews,
screening and selection criteria, proprietary econometric modelling, sector and stock weight ranges, maximum and
minimum number of holdings, risk monitoring, and a selling discipline. Outstanding organizations demonstrate
unique elements or innovative ways of combining elements.
There are a countless number of ways to combine process elements into an investment approach. For instance, a
manager with a fundamental value philosophy might begin selecting stocks from a universe using one or more of
the following screens:
• Low P/B
• Low P/B and high ROE
• Low P/E
• Low P/E using normalized or adjusted earnings
• Low P/sales and high profit margins

This is far from an exhaustive screening list. To finally select stocks for purchase, the manager may demand the
current price be marked down at least 25% from a discounted free cash flow figure. Another manager might
approach the value definition as a discount to the fair market value of the company’s business segments. The
manager may ignore P/B and P/E altogether and focus on qualitative elements such as management, corporate
outlook, and barriers to entry.

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In contrast, a typical fixed-income manager may start with a long-term, top-down view of the bond market and
make a three- to five-year forecast. The firm’s specialists in each sector of the bond market might gather for a week
every year to generate a long-term forecast. Additionally, meetings might be held on a quarterly basis to identify
shorter-term trends. These top-down views could be combined with the bottom-up views generated by the sector
specialists and by quantitative and credit research to identify strategies consistent with the manager’s long-term
views.
Whatever process is used, mutual fund investors should favour those firms that emphasize a team-based approach
to managing money. Investment fund firms are generally organized in one of two ways. In a team-oriented
approach, an individual may or may not have total decision-making power, but the structure of the investment
process is very team dependent. The other approach places final decision-making power for the portfolio on an
individual manager and is common in one-person firms and other small firms.
An investment approach that emphasizes a team-based decision-making process is better in the context of
succession planning and continuity because no individual has dominant influence on the investment process.
Continuity is important over the long run if the firm is to profitably and reliably execute its investment process if
personnel are lost. All things being equal, it is preferable to select a fund with a team-based process than a fund that
relies on an individual.

PERFORMANCE
Performance considers more than just added value over a given benchmark. It also accounts for a manager’s
consistency, the frequency of positive relative performance, and the risk taken to get return. Consistency of
investment style over time is another factor of performance. Good management more consistently and more
frequently outperforms benchmarks and peers per unit of risk. It is easy to judge past performance but difficult
to project it into the future. While the old saying “past performance is not indicative of the future” holds true, a
thorough performance analysis coupled with an encompassing qualitative analysis should increase the odds of
selecting a winning mutual fund.
Style analysis (discussed in greater detail in Chapter 17) is the study of style drift in a fund’s holdings or returns over
time. Style drift is given important consideration in performance analysis for several reasons. A small-cap manager
that invests in large caps during a period of small-cap underperformance cannot be said to be a skillful small-cap
manager. Generally, the relative performance of a portfolio with a significant style bias will depend largely on
whether or not the specific style has performed well. The style differences may dominate the relative returns even
if the manager has skill in selecting stocks. The more style drift that exists in a manager’s investment approach, the
more difficult it becomes to separate any manager skill from sheer coincidence. Furthermore, style drift makes it
more difficult to ascertain the appropriate risk level of the fund. Without a grasp of the risk, it is impossible to set an
ideal asset allocation ratio.

CONSIDERATIONS FOR INVESTMENT SELECTION

Management fees and Unlike investing directly in equity or debt securities, mutual funds require investors to
expenses pay ongoing management fees and expenses. Over time, these expenses represent a
significant drag on performance.

Not suitable for short- With a few exceptions, specifically money market and other short-term funds, mutual
term investment funds are designed to be held as long-term investments and may be inappropriate for
active traders. In addition, because their holdings in long-term securities are subject
to market fluctuations, mutual funds are generally not a suitable investment for an
individual’s short-term emergency reserves.

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WHAT ARE CLOSED-END FUNDS?

A closed-end fund is an actively managed fund that initially raises capital by selling units to investors, after which
additional units are rarely issued. The manager of the fund uses the fixed pool of capital to purchase and manage a
basket of securities according to a specific investment mandate, for which the manager is paid a management fee.
In general, the management fee charged by a closed-end fund is lower than the management fee of a mutual fund
with a similar investment objective.
Once issued, the units are listed for trading on a stock exchange. Investors who wish to buy or sell units of the fund
must do so through a stock exchange. Like any other exchange-traded security, the price at which the units trade
is based on supply and demand. Investors also pay a commission to their dealer to buy or sell units in a closed-end
fund.
Although the actual price of a closed-fund unit is based on supply and demand, the manager of the fund calculates
and publishes the fund’s NAVPS, which is calculated as it is for all other managed products: fund assets minus fund
liabilities divided by the number of units outstanding.
With closed-end funds, there is no arbitrage-based link between the trading price and the NAVPS (as there is with
ETFs) because investors cannot buy units from the fund nor can they sell units to the fund, either for cash (at a price
equal to the NAVPS) or for a basket of securities similar to the fund’s holdings. As a result, closed-end funds may
trade at a premium to, on par with, or at a discount to the NAVPS. Historically, most closed-end funds have traded
at a discount to their NAVPS.

CLOSED-END FUND DISCOUNTS

Research has been conducted to explain why closed-end funds persistently trade at a discount to their NAVPS.5
Although more research needs to be completed, the following explanations have been proposed:
• The inability of the closed-end fund’s managers to properly calculate the fund’s NAVPS
• The role of the timing of taxes paid by investors in a closed-end fund
• Management issues, including manager performance and management fees

None of these theories has been able to answer all of the questions relating to the pricing of closed-end funds.
Research has also focused on the rationality (and irrationality) of investors in closed-end funds. The risk presented
by irrational investors, which is unpredictable and therefore cannot be diversified away, is cited as the reason why
rational investors will buy a fund only if it trades at a discount. The theory states that a rational investor wants to be
compensated for this risk, and the compensation comes in the form of a discount to the fund’s NAVPS.
Research on the relationship between investor sentiment and closed-end funds has found that:
• New closed-end funds are created when existing closed-end funds sell at a premium or at a small discount.
• Discounts are correlated with the prices of other securities that are affected by the same investor sentiment,
such as small-cap stocks.
• Discounts on similar funds (for example, country funds) move together.

5
Much of the following discussion on research into closed-end fund discounts is based on The Closed-End Fund Discount, by Elroy Dimson and
Carolina Minio-Paluello (The Research Foundation of AIMR, 2002).

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THE USE OF CLOSED-END FUNDS IN A CLIENT PORTFOLIO

Closed-end fund units are usually issued at a premium to their NAVPS. Over time this premium tends to turn into a
discount. The following key points about closed-end funds should be explained to clients:
• Closed-end funds are listed on and traded through a stock exchange. This feature offers the advantage of
the ability to purchase and sell (including short sell) at any time throughout the trading day. A disadvantage,
however, is that an investor is subject to bid-ask spreads and liquidity concerns.
• After the initial units are issued, fund managers are not concerned about additional flows of cash into or out
of the fund. Therefore, fund managers can remain focused on executing their investment strategy without
concerning themselves about redemptions or additions to the fund. Fund managers could potentially be fully
invested at all times if they choose.
• A fund could trade at a premium or discount to its NAVPS, but a closed-end fund usually trades at a discount.

WHAT ARE WRAP PRODUCTS?6

Wrap products include wrap funds and wrap accounts. Wrap funds are portfolios of managed products “wrapped”
together and sold as a single product. Wrap accounts are accounts for which a qualified portfolio manager is
authorized to select securities and execute trades on behalf of a client. The securities can include mutual funds,
pooled funds, or individual securities such as stocks and bonds.
Wrap products, which are often referred to as portfolio solutions, have become very popular over the past 15 years
and have been marketed as a way for advisors to spend less of their time selecting investments for their clients and
more on providing value-added solutions such as retirement, estate, and tax planning.
There are two basic types of wrap products:

Funds of funds (FoFs) Invest in portfolios of other managed products, usually mutual funds. Investors purchase
units of the FoF but have no say over which funds or the weighting of those funds in
the fund of funds. Most FoFs are designed to target a specific risk tolerance, which
determines the relative weighting of the underlying funds. For example, a conservative
fund of funds will have a greater weight in mutual funds that invest in debt securities
than it will in mutual funds that invest in equity securities.

Separately managed Target investors with higher levels of investable assets. Accounts are managed on a
wraps (or simply wrap segregated basis, thereby enabling the client to own individual securities. The client
accounts) selects from a range of professional money managers to manage her portfolio. These
programs have higher minimum investment requirements than other wrap products,
usually starting in the $150,000 range.

6
This section draws heavily on material in the quarterly Fee-Based Report, published by Investor Economics. The material is used with
permission of Investor Economics.

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WHAT IS OVERLAY MANAGEMENT?

Overlay management is a service that combines several managed investment products into a single account
controlled by a single authority. Conventional portfolio construction, unlike overlay management, merely combines
separate accounts for each managed product, multiplying the administrative work. This makes it difficult to
efficiently rebalance portfolios or to customize investment solutions for clients. Under overlay management,
customization and efficient rebalancing are possible.
Advisors had historically focused on individual security selection in the management of their client’s portfolios.
However, the advisor went from security selection to the selection of various types of managed products such as
mutual funds, separately managed accounts, exchange-traded funds (ETFs), and hedge funds. The term overlay
management comes from the fact that the advisor overlaid his expertise on top of the investment managers of the
managed products.

GROWTH
A large portion of the Canadian wealth management community has incorporated overlay management into their
practice. The two primary factors for this growth are as follows.

INCREASED FINANCIAL MARKET COMPLEXITY

The combination of rapid growth and innovation of financial markets, plus the impacts of globalization on both
global economies and individual companies, while creating new investment opportunities, has made the challenge
of beating market returns more difficult for the traditional stock picking advisor.
With this in mind, many advisors acknowledge that certain investment decisions are best left to other investment
professionals and organizations that focus all of their efforts and resources on managing particular types of
investments or sectors of the financial markets. Accordingly, they have retained the asset mix and sector investment
decisions, but then utilize managed products to execute the chosen strategy for the client. Essentially, they have
decided that it is better to outsource the required investment management skills rather than attempt to replicate
them with limited resources.

BETTER TIME AND RESOURCE ALLOCATION FOR THE ADVISOR

Another challenge for advisors is growing their business in terms of assets under management. The advisor must
plan and decide upon the optimal split of limited time and resources between the two major competing activities,
providing and marketing investment services to current and prospective clients and actively managing client assets
in the financial markets.
Managed products are viewed by many advisors as a method to reduce the amount of time to actively manage
client portfolios to allow them more time to focus on servicing current clients and acquiring new ones.

CHANGES IN THE ROLE OF THE ADVISOR

Although the advisor remains solely responsible for the overall effective management of client portfolios, the focus
of the role has changed somewhat within the realm of overlay management.
The advisor is now essentially a “manager of investment managers” rather than the sole investment manager. The
focus is now on investing client’s funds with best-of-class investment managers to obtain the optimal performance
for a client.

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The improvement in efficiency gives the advisor more time to focus on providing current and prospective clients
with a more complete and competitive package of wealth management-related services and products. The advisor
can offer more holistic wealth management services that include:
• individual and personal insurance products
• business and estate planning
• limited partnerships
• hedge funds
• tax planning services

Additional products and services give the advisor the opportunity to strengthen relationships with current and new
clients, as well as diversify their source of income beyond the standard commission and other transaction-related
types of fee income.

SKILLS REQUIRED FOR SUCCESSFUL OVERLAY MANAGEMENT

Advisors need to be proficient in a number of specific skills to be successful at overlay management. The primary
skills are as follows:

SELECT INVESTMENT MANAGERS – DUE DILIGENCE

Arguably, the most important skill required is the ability to perform a proper and effective due diligence of managed
products. There are two main aspects to this process.
1. The ability to understand and assess the pure investment-related skills and abilities of the investment
manager(s) responsible for actual investment-related aspect of the managed product.
2. The ability to assess and rate the non-investment-related aspects of the various managed products being
investigated. These aspects include any unique terms, conditions and costs associated with each individual
managed product. Terms, conditions and costs vary across different types of managed products – say mutual
funds versus hedge funds – but, they can also vary materially within one type or class of managed product. An
example of this would be the varying range of ‘lock-up’ time periods for hedge funds.

ALLOCATE MANAGED PRODUCTS WITHIN AN ASSET ALLOCATION

One core competency of an advisor is the ability to correctly utilize appropriate asset allocation techniques and
processes for each client – even if overlay management is not currently utilized. The advisor must be able to apply
these models correctly when creating and managing the asset allocation for clients who are invested in managed
products. The use of managed products still does not diminish the need for the ability to create an efficient asset
mix for each client.

ACCOMMODATE OVERLAY MANAGEMENT IN INVESTMENT POLICY STATEMENTS

Advisors must ensure that client investment policy statements (IPS) properly accommodate the potential inclusion
of managed products. The IPS should identify the specific role that managed products will play in the management
of the portfolio. The investment guidelines section of the IPS should also list in detail what types of managed
products are permitted for investment.

ENSURE ACCURATE REPORTING OF PERFORMANCE NUMBERS

The advisor is solely responsible for the timely delivery of complete and accurate statements and performance
numbers to the client. Accordingly, when considering an investment in managed products, the advisor must ensure
that the information regarding the client’s holdings in managed products lives up to the current high standards of

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service and care. The advisor must ensure that the relevant information provided by the managed product managers
is complete, accurate and received in a timely manner in order to be consolidated into a single report form for
distribution to clients. If the advisor completed proper due diligence, the selected managed product manager will
deliver data accurately and on time.

ASSESS WHOLESALING SUPPORT

The advisor must clearly understand the nature and amount of support the managed product wholesaler can
provide both pre- and post-sale. The advisor needs wholesaling support in terms of the specific materials and
assistance provided during the due diligence process, as well as quality and frequent information provided post-sale.
Overlay management not only outsources investment skills but it also outsources the servicing supporting that
product.

PROS AND CONS

Before implementing overlay management, the advisor needs to weigh the pros and cons of single security
selection versus investment in managed products. Some of the main points of comparison between the investment
management methods are as follows:

Aspect Single Security Selection Managed Products

Diversification More difficult to accomplish, Usually well diversified (whether

especially with smaller-sized broad sector/asset class mandate
portfolios. Can increase risk or sub-sector mandate)
for client

Degree of control over investment Very high None

strategy by the advisor

Ability to demonstrate security Yes No, managed products are

trading skills generally not designed to be traded

Trading commission income Yes, depending on amount of None; advisor’s income is in the
trading and degree of success form of trailer fees and/or asset
management fees

Ability to measure and report on Yes, client reports provide Yes, managed accounts generally
investor’s total exposure to both investment details on a ‘security- provide this level of detail regarding
individual securities and individual level’, sector, sub-sector and security trading and holdings –
security market sectors and asset class basis however the advisor might not be
sub-sectors (diversification – risk able to consolidate this information
management) with the client’s other managed
account investment(s) and
individual security holdings (if any)

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Aspect Single Security Selection Managed Products

Ability to control realized capital Yes (to the extent that unrealized No, the advisor has no control over
gains and losses in client’s total gains exist) the realizing of gains/losses – other
portfolio on an annual basis – ‘tax than selling the managed product
loss harvesting’

Efficient use of advisor’s time Advisor spends a larger portion (Potentially) yes, since the
of his time researching and advisor has to spend less time
trading individual securities. and effort researching individual
Done correctly, this takes time securities – which can be quite time
to do correctly, and accordingly consuming if done thoroughly.
reduces the amount of time Allows the advisor to spend more
available to service current time servicing current clients and
clients and prospect for new ones marketing to new prospects

The security selection management style may be the most optimal for an advisor (and clients) if the advisor has
demonstrated security selection and trading skills, and consistent results to prove it. However, to be effective
at single security selection normally requires a significant allocation of the advisor’s time and can lead to a sub-
optimal business outcome for the advisor since less time is available to service current clients and effectively
prospect for new ones.
Upon consideration of the pros and cons of the two investment management methods described, more and more
advisors over the past decade have decided to utilize overlay management for most, if not all, of their clients.
Admittedly, some advisors have decided upon a strategy whereby most of each client’s assets are invested in
managed products with a very small portion, typically less than ten percent of total, being managed under a single
security selection management strategy.

RECENT TRENDS IN OVERLAY MANAGEMENT

Along with its increased popularity, overlay management has also undergone some evolution and refinement
in terms of the level of sophistication with which overlay management is applied. The evolution of overlay
management is summarized in the diagram below.

Portfolio of Individual Securities

Mutual Funds / ETFs / Hedge Funds

Time

Separately Managed Accounts (SMA)

Unified Managed Accounts (UMA)

Unified Managed Household Accounts (UMHA)

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The first attempt to ‘consolidate’ overlay management was with the use of separately managed accounts (SMA).
Administratively, the traditional SMA required a new account to be opened for each managed account manager or
product. In this traditional SMA world, advisors could never reference the decisions of other managers in the client’s
account to ensure that their decisions made sense in the context of the client’s overall portfolio. This limitation
could lead to some problems for the client:

Reduced The client could end up in a situation where their total exposure to particular markets,
Diversification sectors, or even individual securities was higher than the investment guidelines and
restrictions portion of their IPS permitted. This could occur in a situation where a number
of the different managed account managers simultaneously increased their exposure to
a particular company and/or industry as they independently, but collectively, saw, and
pursued, an investment opportunity develop in the markets. The client could end up
over-exposed to that sector or company since the advisor had no real time method of
calculating the clients overall investment portfolio in detail and accordingly could not
measure this exposure versus the IPS’s restrictions.

Income Tax Liability The client will have a different tax basis, or cost, for each individual security held in the
various managed accounts. Although the advisor normally is, or should be, aware of the
client’s current income tax situation, this information is not consolidated for the client’s
total investment portfolio. This lack of information, and control over the managed
account manager, results in the advisor being unable to have control over the decision
to trigger capital gains and/or losses in order to optimize the client’s individual current
income tax exposure and situation. This would result in situations where a client’s
current income payment was larger since the timing or gains and/or losses was not taken
into account by the portion of the client’s assets invested in managed accounts.

These two limitations, among others, led to the development of unified managed accounts (UMAs). These
accounts are not really new types of accounts but rather are essentially software tools and data feeds that eliminate
the shortcoming associated with SMAs. In a properly functioning UMA, the advisor is able to monitor the client’s
overall portfolio of managed accounts to the appropriate level of detail to ensure that the following are always
monitored and therefore adhered to for the client:
• All investment guidelines and restrictions are adhered to (at both the individual managed account level and the
overall portfolio level).
• Tax management can be controlled including active loss harvesting to reduce current income tax liability.

Both the growth of and unique limitations of SMAs resulted in the UMA product being developed. It is made
possible due to two technological factors:
• The ability for managed account managers to transfer all of the relevant portfolio information (i.e., individual
security holdings, tax basis, market values, portfolio weightings) to the advisor on a timely basis (often daily)
over the Internet.
• The development of PC-based software that enables the advisor to consolidate all of the data feeds from the
various managed account managers.

In essence these two factors enable the advisor to see the client’s vast mix of various managed account holdings as
one single portfolio to which IPS investment guidelines and restrictions can be tested in real time, and income tax
management can be managed in the optimal manner.

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 CHAPTER 11 | ANALYSIS OF CONVENTIONALLY MANAGED PRODUCTS 11 • 17

The evolution and development of overlay management continues to this day – with the development of the
unified managed household account (UMHA). As the name implies, a UMHA provides all of the features,
information and controls afforded by a UMA, but in this case, the UMA is applied to the client’s entire household
and/or family office situation, rather than applying it just to the client as an individual. This allows the advisor to
manage the client’s portfolio while incorporating all of the other considerations arising from the client’s household
situation and/or family office situation.

WHAT ARE FEES AND TURNOVER?

MANAGEMENT FEES
For any managed product, management fees reduce the return on the investment. Management fees vary within
and among the various types of managed products, and they should not be the only consideration when choosing a
managed product.
In general, management fees are lower on passively managed products such as index mutual funds than on actively
managed products such as closed-end funds and equity mutual funds. The higher fee charged by active managers
is compensation for, among other things, increased research costs associated with making investment decisions for
the fund. However, by investing in actively managed products, investors expect to achieve a return greater than that
of a passively managed investment.
Management fees have a relatively significant impact on the performance of index funds, fixed-income funds, and
money market funds. There is a high correlation between low management fees and top-quartile performance.
Index and debt securities funds have less scope to add value to outperform their competitors, and thus most of the
difference in performance can be traced to a difference in management fees. The impact of fees is also magnified
by the fact that absolute performance on bonds and money market securities tends to be lower than for equity
securities.

PORTFOLIO TURNOVER
Portfolio turnover is roughly defined as the total value of securities bought and sold in relation to the overall net
assets of the portfolio. Higher turnover implies that more securities were bought and sold. Since trading costs are
ultimately paid by the fund’s investors, higher turnover results in greater expenses and, all else being equal, a lower
return.

EXAMPLE
If the turnover of Fund A was 120% and the turnover of Fund B was 85%, then Fund A has bought and sold more
securities relative to its size than Fund B. If these two funds were identical in all aspects except for their turnover,
then Fund B would have a greater return than Fund A.

Every Canadian mutual fund is required to disclose historical turnover rates in its simplified prospectus. In addition,
if a mutual fund’s turnover is expected to be more than 70% in future periods, the prospectus includes a statement
that explains how the tax consequences and trading costs associated with the turnover may affect the mutual
fund’s performance.

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WHAT IS THE RELATIONSHIP BETWEEN TAXES AND RETURNS ON

CONVENTIONALLY MANAGED PRODUCTS?
The taxation of investments is an obvious concern to any investor when the investment is held outside a registered
account such as an RRSP. In a non-registered account, interest income, dividends, and capital gains are subject to
varying levels of taxation in Canada. Unfortunately, with managed products, especially actively managed mutual
funds and to a lesser extent passively managed products, capital gains can arise without the client selling the
managed product. Net capital gains are equal to realized capital gains less realized capital losses. If this number is
positive, then the managed product will distribute the net capital gains to unitholders, and this amount is taxable.
A portfolio that buys and sells securities more often thus has higher portfolio turnover, which may result in higher
capital gains distributions to investors. After all, more active trading is supposed to result in more realized gains.
Higher portfolio turnover in a managed product does not automatically signal higher capital gains distributions.
The higher turnover may be the result of the portfolio manager selling securities to realize gains against realized
capital losses in the portfolio. Or the manager may sell securities at a loss to offset realized capital gains.
An investment advisor needs to explain to the client before making any investment that if a managed product,
especially an actively managed mutual fund, increases in value by 25% over a January-to-December period during
which the client held the fund, that this is a positive development, even though some securities may have been
bought and sold to achieve this gain. A client who bought the same fund late in the year, however, may not see
things the same way, especially if the fund had a negative return for the latter part of the year. If the client owned
the fund on the day of the distribution, then the client has to pay tax on the distribution, even though the fund is
worth less than the amount the client paid for it.
Index-linked managed products, including index mutual funds and ETFs, implicitly force investors to take capital
gains because of the rebalancing required to keep the fund’s contents and weights in line with those of the
underlying index.
A study examined returns over a 10-year period for 343 equity and balanced mutual funds managed by Canadian
companies and marketed predominantly to Canadian investors.7 The authors noted that Canadian mutual funds do
not have to disclose their after-tax investment returns. After making some general assumptions about the tax rates
of investors in the fund, the authors found that taxes reduce long-term investment returns to a greater extent than
management fees and brokerage commissions.
The authors also concluded that rankings of funds on a pre-tax basis differ significantly from the rankings of those
same funds on an after-tax basis. The article states that the average fund moved 28 spots (on a list of 343 funds)
higher or lower in ranking after taxes had been accounted for. Funds that ranked near each other on a pre-tax basis
had a 46% probability of having their ranking reversed on an after-tax basis. In addition, the report found that an
individual investor in the highest marginal tax bracket would have lost approximately 15% of the annualized pre-tax
return to taxes on fund distributions, for an average fund during this time period.

7
Amin Mawani, Moshe Milevsky, and Kamphol Panyagometh, “The Impact of Personal Income Taxes on Returns and Rankings of Canadian
Equity Mutual Funds,” Canadian Tax Journal, 2003, vol. 51, no. 2, pp. 863-901.

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 CHAPTER 11 | ANALYSIS OF CONVENTIONALLY MANAGED PRODUCTS 11 • 19

SUMMARY
By the end of this chapter, you will be able to:
1. Explain the role of conventionally managed products in a portfolio.
• The choice of whether and how extensively to use managed products depends on the client’s needs. The size
of the client’s portfolio and the need for diversification are also considerations.

2. Explain the relative suitability of mutual fund investments.

• An investor must consider five elements of mutual funds before selecting suitable candidates: personnel,
business, philosophy, process, and performance.
« Personnel: Evaluation of the portfolio manager and the investment team might be the most important part
of the mutual fund assessment process.
« Business: The business should finance day-to-day operations, including overhead, technological
infrastructure, and salaries plus bonuses and profit sharing.
« Philosophy: refers to a coherent way of thinking about how markets work and how they might be
incorrectly priced. Equity and fixed-income philosophies can each be classified into distinct styles. Equity
styles include value, growth, sector rotation, momentum and growth at a reasonable price. Fixed-income
styles include interest rate anticipation, security selection, sector trading and high yield.
« Process: has two outstanding qualities:
• Elements that are verifiable and transparent. Process elements are the factors used and the way they are
co-ordinated to value assets.
• Decision-making procedures that are team based. Investors should favour firms that emphasize a team-
based approach because it lessens the dependence of the fund on a single individual and promotes
continuity.
« Performance: includes evaluating the risk-adjusted rates of return and also style analysis which looks at the
drift in a fund’s holdings over time as compared to the holdings defined by the stated investment style of
the fund.

3. Describe the features of various managed products.

• Mutual fund: is an open-ended investment company that is structured either as a corporation or as a trust and
that raises capital by issuing shares (in the case of a mutual fund corporation) or units (in the case of a mutual
fund trust). A mutual fund is in a continuous state of distribution
• Closed-end fund: is an actively managed fund that initially raises capital by selling units to investors, after
which additional units are rarely issued. Once issued, the units are listed for trading on a stock exchange.
• Wrap products: include wrap funds and wrap accounts. Wrap funds are portfolios of managed products
“wrapped” together and sold as a single product. Wrap accounts are accounts for which a qualified portfolio
manager is authorized to select securities and execute trades on behalf of a client. The securities can include
mutual funds, pooled funds, or individual securities such as stocks and bonds.

4. Explain overlay management.

• Overlay management is a service that combines several managed investment products into a single account
controlled by a single authority.

5. Advise a client of advantages and disadvantages of overlay management.

• Some of the main points of comparison of single security selection versus managed products are:
diversification, degree of control over the investment strategy by the advisor, ability to tax loss harvest, and
efficient use of the advisor’s time.

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6. List the various techniques through which to obtain overlay management.

• The first attempt to consolidate overlay management was with the use of separately managed accounts. The
next development in overlay management was unified managed accounts and the next development was
unified managed household accounts.

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 Analysis of Non-Conventional
Asset Classes and their 12
Structures

CONTENT AREAS

What Is an Alternative Investment and why Invest in Them?

What Are Hedge Funds?

What Are Commodities?

What Is Real Estate?

What Is Private Equity?

What Are Collectibles?

What Are the Ways to Invest in Alternative Investments?

How Do Commodity Producers Manage Financial Risk?

What Are the Ways To Invest in Real Estate?

What Are the Ways To Invest in Private Equity?

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LEARNING OBJECTIVES

1 | Explain what an alternative investment is.

2 | Describe hedge fund risk drivers.

3 | Explain criteria for hedge fund investment.

4 | Describe how commodities may fit into an investment portfolio.

5 | Compare the different methods of investing in commodities.

6 | Explain the merits of using real estate in a client portfolio.

7 | Compare the ways to invest in real estate and mortgages.

8 | Explain the benefits and risks of private equity investing.

9 | Compare the ways in which to invest in private equity.

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 CHAPTER 12 | ANALYSIS OF NON-CONVENTIONAL ASSET CLASSES AND THEIR STRUCTURES 12 • 3

INTRODUCTION
The two most recent recessions pushed interest rates to multi-decade lows. Retirees suddenly saw returns from
their fixed-income investments shrink by half or more. Defined-benefit pension funds unexpectedly could not meet
their actuarial returns. Yield-hungry and risk-averse investors sought out alternative investment products, such
as hedge funds, commodities, private equity and real estate, as a means to preserve their capital and bridge the
return gap.
Alternative investments, in one form or another, have been in existence for several decades. Once the choice of
only wealthy individuals, alternative investments have now moved into the mainstream and are within reach of
even the average investor. However, investing in alternative assets is not subject to as much regulation as investing
in conventional asset classes. Also the markets in which they trade can be more complex and illiquid. Thus due
diligence takes on an even greater importance for the individual investor.
This chapter looks at the five main classes of alternative investments, their unique features, risks and benefits.
The chapter also examines the different means by which investors can access these investments.

WHAT IS AN ALTERNATIVE INVESTMENT AND WHY INVEST IN THEM?

Alternative investments are asset classes that are different from the traditional three broad asset classes of
equities, bonds and cash. There are three main reasons why an investor would include alternative investments in a
portfolio:
1. To incrementally increase returns more than incrementally increasing the risk.
2. To incrementally decrease risk more than incrementally decreasing the return.
3. To increase the absolute-return nature of the portfolio, making it more resistant to capital erosion in market
downturns.

Alternative investments allow the investor to move to a higher efficient frontier by increasing the number of
opportunities available, increasing portfolio diversification and risk control, and adding superior risk/return potential
to the portfolio. Also, many alternative investments target absolute returns, which means they aim to produce
positive returns regardless of market direction.
In the next sections, we turn our attention to the various classes of alternative investments.

WHAT ARE HEDGE FUNDS?

Hedge funds are lightly regulated pools of capital with managers that have great flexibility in their investment
strategies. In Canada, as in many other countries, hedge fund managers are not constrained by the rules that
apply to standard mutual funds. They can take large short positions, use leverage and derivatives for speculation,
perform arbitrage transactions (which exploit perceived price differentials to make a profit) and invest in almost any
situation in any market where they see an opportunity to achieve positive returns.
Because hedge fund managers have tremendous flexibility in the types of strategies they can employ, the manager’s
ability to select superior investments within the targeted strategy and within relevant markets is more important
for hedge funds than for almost any other managed product. Hedge funds do not have a unique legal structure
(they may be structured as trusts or limited partnerships, for example), and their investment objectives and investor
suitability vary depending on the manager’s choice of strategy and the targeted risk/return level. Some hedge funds
are conservative, while others are more aggressive. Despite the name, some funds do not hedge their positions at
all. Therefore, it is best to think of a hedge fund as a type of fund structure.

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HEDGE FUND RISK DRIVERS

There are a number of sources of hedge fund risk, and below we discuss what differentiates first-order risk (or
directional risk) from second-order risks (such as liquidity risk, default risk and leverage risk) and from a third
category of risk not specifically related to the hedge fund’s strategies, operational risk (or business risk). The terms
first-order risk and second-order risk are used to classify risks related to a hedge fund’s investments and trading
processes. These risks directly affect the overall risk and return of hedge funds.
First-order risk refers to exposure to changes in the general direction of equity, fixed-income, currency and
commodity markets. The source of risk is market-induced or systematic (which cannot be reduced through
diversification). First-order risk does not affect relative value strategies or event-driven strategies to any significant
degree. It does, however, affect directional strategies, which, by definition, are based on a hedge fund manager’s
views about the direction of different markets, interest rates, commodity prices and currencies.
Second-order risks include liquidity, leverage, deal-break, default, counterparty, trading, concentration, pricing
model, and trading model risks. These risks, unlike first-order risk, are not related to the market but to other aspects
of trading, such as dealing, implementing arbitrage structures, or pricing illiquid or infrequently valued securities.
The third type of risk, operational risk, relates to the hedge fund as a business entity and stems from the fact
that many hedge funds are small, newly created businesses that depend on one or more high-profile managers for
their success. Such organizations are highly focused on promoting and supporting the skills of the manager(s) and
may lack the organizational depth, managerial talent and strategic planning capabilities necessary to ensure growth
or even survival. For most hedge funds, operational risk stems from potential system failures as well as faulty
settlement, reporting and accounting procedures. Operational risk is significant in single-strategy funds and needs
to be addressed through due diligence.

WHAT ARE COMMODITIES?

Commodities are another class of alternative investments. Commodities are the basic homogenous materials
produced and consumed by the world’s economies. Some commodities are used mainly for consumption (the
commodity eventually becomes a product that is consumed) while others are used primarily for investment
purposes. Commodities can be accessed using the derivatives markets or actual holding of the physical material.
The types of commodities that underlie major world markets include agricultural products, precious and industrial
metals, and energy products.

TYPES OF COMMODITIES
In this section we describe the many different types of commodities.

GRAINS AND OILSEEDS

The grain and oilseed category of agricultural products includes wheat, corn, soybeans and canola. It is the oldest
category of derivatives contracts. The primary trading interest comes from speculative and hedging activities by
farmers, food processors, grain storage firms, exporters and foreign countries that import grain. These markets are
heavily influenced by agricultural production, weather, government farm policies and international trade.

LIVESTOCK AND MEAT

The livestock and meat category includes pork bellies, hogs, live cattle and feeder cattle. Prices of livestock and
meat contracts are affected by the domestic and worldwide demand for meat and by indirect factors such as prices
of grains used as feed, government policies, demographic trends and international trade. Traders in this category
include farmers, slaughterhouses, meat packers and major users of beef and pork, such as fast-food restaurant
chains.

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 CHAPTER 12 | ANALYSIS OF NON-CONVENTIONAL ASSET CLASSES AND THEIR STRUCTURES 12 • 5

FOREST, FIBRE AND FOOD

This diverse category of commodities includes lumber, cotton, orange juice, sugar, cocoa and coffee. As most of
these commodities are imported or exported, international economic and political conditions are key factors.

PRECIOUS AND INDUSTRIAL METALS

These commodities include metals used in jewellery and industrial products, such as gold, silver, platinum, copper
and aluminum. Each is considered a non-renewable natural resource. Much of the production is located overseas,
often in politically unstable countries. Worldwide demand and supply have a greater impact than domestic demand
and supply. As a consequence, international economic and political factors play a crucial role.

ENERGY PRODUCTS
Energy products include crude oil, heating oil, gasoline, natural gas and propane. These commodities provide energy
sources for automobile, manufacturing, telecommunications, agricultural and other industries. The importance
of these commodities is underscored during energy crises. Prices of these commodities depend on worldwide
production and demand which, in turn, are influenced by the international economic and political environment.

WHERE MIGHT COMMODITIES FIT IN A PORTFOLIO?

There has been increasing interest among academic researchers about the role of commodities in asset allocation.
One study that has frequently been referenced is the independent research report conducted by Ibbotson
Associates (commissioned by PIMCO in 2006).

PIMCO/IBBOTSON AND ASSOCIATES

PIMCO, one of the world’s largest investment management companies, commissioned this study in 2006 because
it felt that there was still little research regarding the appropriate size of an allocation to commodities. PIMCO
felt unable to answer its clients’ questions as to how much to allocate to commodities and decided it needed an
independent analysis in order to fill this gap in the research.1
Ibbotson’s study was divided into two main parts, one based on historical analysis and the other based on a
projection of three forward-looking return assumptions for commodities.
In the first part of the study, Ibbotson drew the following main conclusions about the historical role of including
commodities in a strategic asset allocation:
1. Over the 35 years covered in the study, commodities provided the highest return of any asset class in the
study, including U.S. equities.
2. In addition to producing the highest returns over time, commodities tended to produce relatively high returns
when traditional assets performed poorly. For example, over the 35 years covered in the study, there were
eight years when U.S. equities posted negative returns. During each of those eight years, commodities posted
the highest returns of any of the other assets included in the study. Commodities also had the highest return
during the two years in the study time period in which U.S. bonds had negative returns.
3. Commodities had the lowest average correlation to other asset classes.
4. Commodities had positive correlation to inflation, which supports the idea that commodities can exhibit real
inflation-adjusted returns.

As commodities produced high returns with low correlation to other assets, the Ibbotson study found that including
commodities in a strategic asset allocation produced a superior efficient frontier at any level of risk relative to
returns, compared to when commodities were excluded.

1
Idzorek, Thomas M., “Strategic Asset Allocation and Commodities,” Ibbotson Associates, March 27, 2006

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In the second part of the study, where three forward-looking return expectations were developed for commodities
using three different analytical techniques, the following observations and conclusions were made:
1. The optimal allocation depended on the method used to project future commodity returns:
• At the moderate risk level similar to a standard portfolio, comprised of 60% stocks and 40% bonds, the
optimal allocation to commodities ranged from about 22% to as high as 29% depending on the forecasting
method used.
• At the conservative risk level, optimal allocations to commodities varied from about 9% up to nearly 14%.
2. Regardless of the method used to project future commodity returns, portfolios that included commodities
in the opportunity set were also more efficient than those that excluded commodities, based on their risk-
adjusted return (the Sharpe ratio is discussed in chapter 17).

Even with a large decrease in expected commodity returns, the optimal commodity allocations remained above 11%
in all three models.
Although PIMCO felt that organizational constraints would in most cases limit the allocation to commodities in
the single-digit range, the study did provide independent support that a zero allocation to commodities would be
too low.

WHAT IS REAL ESTATE?

Real estate refers to land and/or any of the fixed assets (residences, buildings, and factories) built upon it. Real
estate is considered an alternative investment even though it has been an important investment for investors over
thousands of years. The real estate market is segmented into the commercial, industrial and residential sectors.
Real estate becomes a liquid investment when it is securitized – when shares in a pool of real estate assets are
resold to investors, as in the case of REITs (real estate investment trusts). Physical real estate and securitized real
estate are two key aspects of real estate as an investment. Many investors hold physical real estate in the form
of primary or secondary residences, or as investment properties. Physical real estate has several distinguishing
features.
• For the average retail investor, residential property is one of the few investments that can be leveraged, or that
the investor will feel comfortable leveraging (as opposed to shorting or margining investments). It is arguably
the single most important collateralized asset owned by investors. Other types of property can be leveraged
as well.
• Real estate investment costs, similar to other investment fees, can be high. Appraisal, due diligence,
maintenance and repair costs all affect an investment’s return and need to be factored into the potential net
returns that can be generated from property.
• Tax issues are important in holding real estate. In particular, municipal taxes, water taxes, school taxes and
other taxes levied on the value of property or at disposition need to be considered.
• Real estate may represent a significant portion of an investor’s total net worth. Because of this, when
completing asset allocation, the advisor should whenever possible include real estate holdings in the analysis.
• Real estate competes with market investments as it provides current consumption value that other investments
may not. The implicit rental value of property needs to be taken into account, as it represents an opportunity
cost of holding and occupying physical real estate.
• Real estate is inflation-sensitive. It will fluctuate with inflation and tends to protect the portfolio from the
effects of inflation.

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 CHAPTER 12 | ANALYSIS OF NON-CONVENTIONAL ASSET CLASSES AND THEIR STRUCTURES 12 • 7

• With potentially long holding periods, depending on the type and purpose of the investment, real estate can
stabilize overall portfolio returns, although it can have high volatility (real estate markets are subject to boom-
and-bust cycles).
• Overall, real estate can be considered a bond substitute with an added inflation protection feature.
• Real estate holdings are not interchangeable, are expensive per unit and require significant management, care
and maintenance. For these reasons, many investors will not physically hold real estate beyond a principal
residence and perhaps a secondary residence.

FEATURES AND CHARACTERISTICS OF REAL ESTATE

Evaluation of real estate is more complex than evaluation of conventional investment vehicles, differing in the
following important respects:
1. Uniqueness: Each residential or commercial complex real estate parcel, inventory of single-family homes or
portfolio of mortgages has its own particular characteristics. Therefore, comparison with similar investments
and properties is often difficult, although necessary.
2. Interrelationships: The value of one property can be affected by activities and character of adjacent properties.
For example, an office building located next to a slaughterhouse will probably be worth less than one located
next to another office building. Municipalities enact zoning laws to control and restrict activities within a
specific area but existing, non-conforming use buildings are often grandfathered. Relying solely on zoning laws,
which can change, is not sufficient.
3. Immobility: Each property is fixed within its geographic location. If economic activity declines, the property
cannot be moved to a more attractive location.
4. Illiquidity: Generally, exempt real estate investment products are illiquid. Therefore, they should be
recommended only to investors who are able to hold the investment indefinitely or for the specific term noted
in the offering documents.
5. Market inefficiencies: Real estate trades in a relatively inefficient market, compared to the equity market, which
adds extra costs. Real estate market inefficiencies include the following:
• Fragmentation: There is no central market where properties are traded.
• Limited number of buyers at any given time.
• Legal and contractual constraints affecting value: These may include relationships between lessees and
lessors, or mortgagees and mortgagors; land and building usage constraints; and ownership of air rights over,
and mineral rights under, the property.
• Need for property management: Stock and bond purchases include management along with the security.
However, this is not necessarily the case with real estate. Therefore, costs associated with real estate
investments include property management plus legal and transaction costs, which are typically high when
compared with many other investment products.

FEATURES AND CHARACTERISTICS OF MORTGAGE LOANS

Mortgage loans are secured by a lien or charge on real property. A mortgage is classified as conventional if the
mortgage borrower initially pays down 20% or more of the property value. Because real estate values have
historically tended to increase on a long term basis, real estate provides good loan security. Depending on the
specific jurisdiction and the mortgage contract, the lender may have the right to take over the mortgaged property
and sue the borrower for any unpaid loan balance, if the borrower falls into default.

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Investors buy conventional mortgages and mortgage-based investments because the monthly payments include
amortization of the principal and interest. This adds an important safety factor by assuring a definite schedule for
repayment of the loan. The investor not only has capital returned regularly, but it is returned with a rate of interest.
Conventional mortgages cannot be originated with less than a 20% down payment, or a loan exceeding 80% of the
appraised value. However, if granted by a traditional lender, such as a bank, the mortgaged amount can be more
than 80% of the appraised value, if insured by the Canada Mortgage and Housing Corporation (CMHC) or a private
insurer. Lenders also apply income tests and do not lend funds to borrowers who do not meet specific quantitative
tests.

RETURN CHARACTERISTICS OF REAL ESTATE AND MORTGAGE

SYNDICATIONS
Investors and advisors can consult historical returns of real estate by using average prices for housing in most major
markets and published returns for REITs. However, there is no readily accessible information about how real estate
syndications and mortgage syndications have performed. Some individual promoters whose past offerings have
met investor objectives disclose cash distribution figures; others do not. Syndications are not required to file their
financial statements and other disclosures with anyone other than with their investors.
Real estate has tended to appreciate in value in periods of economic expansion and drop in value during periods
of recession. However, real estate syndications as a group tend to fall in the upper end of the risk scale and vary
according to specific types of holdings, use of leverage and other factors.
Mortgage syndications are not suitable for investors who require an assured revenue flow. Conversely, they may be
suitable for investors who desire, but do not require, a much higher return than guaranteed investments provide,
and who fully understand the risks.
Mortgage syndications hold mortgages secured by properties, but they generally do not have the quality of
covenants that are typical with mortgages held in mortgage mutual funds. For example, mortgage syndications may
hold second and even third mortgages, which rank behind the first mortgage. Therefore, if a borrower defaults on
the first mortgage, the syndication will have to pay the arrears on the first mortgage, or face losing its investment if
the holder of the first mortgage forecloses.

WHAT IS PRIVATE EQUITY?

Private equity constitutes an alternative investment class that is attracting considerable interest and investment
dollars from institutional investors, wealthy families and foundations. Private equity denotes investments not
actively traded on public markets.
Private equity is a rapidly growing market and is typically done through funds structured as limited partnerships
(LPs). The promoters are the general partners, while the investors are the limited partners. Funds may be primary
(a round of financing is raised for first-time investing in different opportunities) or secondary (invest by buying back
positions held by primary investors needing to liquidate earlier than the maturity date). Private equity investments
include leveraged buyouts, mezzanine capital, venture capital and infrastructure investments.

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Leveraged buyout A leveraged buyout (LBO) occurs when the buyer of the majority of a company’s shares
finances this purchase through debt, often with the assets of the acquired company
used as collateral for the loan. LBO firms represent some of the wealthiest finance
organizations anywhere, with the ability to raise funds above $10 billion and conduct
multi-billion-dollar deals. LBO funds are structured as limited partnerships, with the
general partners (the promoters of the fund) receiving ongoing compensation and the
limited partners receiving returns contingent on investment performance.

Mezzanine capital A firm may wish to finance by floating high-yielding, unsecured preferred equity or
subordinated loans. This mezzanine capital typically is just above common stocks in
seniority. As such, they are a comparatively costly way to finance. From the private
equity investor’s point of view, the risk of default is about the highest in the debt
spectrum, but the investment pays high returns given the increased credit risk in case of
default.

Venture capital Venture capital is applied to the financing of new, untested companies and business
ventures. It also helps finance growing, early-stage companies (not yet mature or not
ready to issue equity or debt in the mainstream markets) or struggling companies (called
distressed investing). Because of the high risks involved, venture capitalists require the
potential for very high returns and fully diversify their portfolios because several funded
companies will terminate operations or business projects will not reach the market.
Importantly, before investing, venture capitalists require that the firm present a clear exit
strategy, showing how the venture capitalist will be able to divest the investment, either
through an initial public offering (IPO) or an acquisition.

Infrastructure Investments in infrastructure represent massive amounts of capital with a small number
of investing partners. Infrastructure refers to such projects as roads, ports, airports and
water works. In Australia, Europe and North America, there is rapidly growing demand
for private financing of public projects. A well-known Canadian example is the 407
highway in Toronto. The worldwide infrastructure market has been reserved for the
very largest institutional investors, such as the Caisse de Depot’s ownership stake in
Heathrow Airport Holdings. Infrastructure investing is highly illiquid and long-dated.

The following points summarize the features of private equity:

• Private equity fund shares are illiquid, with no specific resale markets (although increases in secondary funds
create greater opportunity for reselling positions).
• Liquidity is low, as typical investment maturities are in the 7- to 10-year range and often longer.
• Private equity investments typically have a higher risk/return profile, with possibly significant default,
counterparty and manager risk (success of a venture capital project, for example, directly depends on key
personnel remaining with the venture).
• The attraction of private equity is that, on average, it has shown long-term returns significantly greater than
traditional equity returns, although with higher volatility.
• Private equity investing is often by invitation, and opportunities may be restricted to seasoned investors.
• Because of long holding periods, private equity investing can be a stable part of a portfolio because adverse
market events will not lead to liquidation and market timing will be less of a factor. Long maturity favours a
more consistent average rate of return.
• Because risk/return levels tend to be high, the role of private equity in the portfolio is as an equity substitute or
as a satellite or complementary position around a more conservative core position.

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• Investment minimums are high and are typically outside the range of most private investors. The development
of lower-minimum funds will likely allow more high-net-worth investors to participate.

BENEFITS AND RISKS OF PRIVATE EQUITY INVESTING

THE BENEFITS INCLUDE:

Superior Returns The long-term returns of private equity investments provide a premium to the
performance of public equities.

Absolute Return Goals Unlike mutual funds, private equity funds are not considered to have had a successful
year if fund returns are negative yet outperform the average return from a peer group.
Private equity managers seek absolute returns and their traditional incentive structure, is
geared towards achieving that goal.

Access to Legitimate Because private equity managers are often buying majority ownership in a company, a
Inside Information much greater depth of information on possible investments is available to them. This
information helps to more accurately assess the likely success of a company’s business
plan.

Influence Over To improve the odds of realizing superior returns on their investments, private equity
Management managers generally seek active participation in a company’s strategic direction.
and Flexibility of Such participation could include development of a business plan, selection of senior
Implementation executives and identification of eventual acquirers of the firm.

Leveraging off the Buyout managers try to organize each portfolio company’s funding to make full use of
Statement of Financial different borrowing options, such as senior secured debt and high-yield debt. Organizing
Position funding requirements this way can enhance equity returns to the private equity
managers. In addition, because the leverage is organized at the company level rather
than at the fund level, the fund and its other investments are protected if the company
becomes insolvent. Thus the investor has the benefit of a leveraged portfolio with less
risk than if the fund used its own leverage.

THE RISKS INCLUDE:

Illiquid Investments Lack of liquidity is one of the key disadvantages faced by private equity investors. For
example, when a venture capital firm purchases shares in a private company, the holding
period is three to seven years, on average. Venture capital fund investors are locked into
their investment during this period. It is possible to sell partnership shares to a third
party, but at a significantly discounted price.

Dependence on Key Private equity funds usually depend on the general partners and a relatively small staff
Personnel for all key investment decisions. Also, private equity managers often take an active role
in the management of companies in which they invest, including participation on the
company’s board of directors. For this reason, the inability of one or more key people to
carry out their duties could have a significant adverse effect on a partnership and on the
return on its investment.

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Down-Market Although private equity provides some degree of portfolio diversification, some of the
Performance diversification benefits are illusory. Partnerships are often valued at cost, which results in
the artificial dampening of the standard deviation and correlation. During down markets,
private equity should perform worse than traditional equity investments because of
private equity’s leveraged capital structure, which results in higher risk. In the event of
an economic downturn, a leveraged capital structure makes bankruptcy more likely. In
addition, private equity investments tend to be in smaller companies. In times of market
distress, smaller companies have a higher chance of failure than larger, well-established
firms.

High Management and Management and performance fees weigh on investment performance and put
Performance Fees additional pressure on managers to perform, which may create a risk bias. Managers
may tend to take higher risk as they need to clear the fee hurdle to generate worthwhile
returns for their limited partners.

“Blind Pool” Investing It is usually not possible, at the launch of a private equity fund, to analyze portfolio
assets before committing because assets have not yet been identified. Likewise, it is
generally not possible to be excused from a particular portfolio investment after the
fund is established. What the investor is buying is not a specified group of assets but
rather the private equity manager’s skill at identifying and managing those assets to
profitability.

WHAT ARE COLLECTIBLES?

Collectibles are rare objects manufactured or hand crafted that have a uniqueness desirable to individuals.
Collectibles include fine art, classic automobiles or rare stamps or coins.
Art investing is traditionally the realm of the high net-worth world and has long consisted of building a collection
and bequeathing it through an estate or selling it at time of death.
Several elements need to be taken in consideration before investing in collectibles. Investing in collectibles entails
significant costs such as auction fees, appraisal costs, collection maintenance, insurance, storage and transportation.
Investors and advisors need a working knowledge of the field of collectibles and a network of specialized contacts to
service client needs
It is also important to note that collectibles generate no income but focus on capital gains. Collectibles are illiquid
and rapid selling may entail significant losses over purchase price. Collectibles such as art also face unique risks,
such as the popularity of the artist and the role of a particular piece in the artist’s career. From an asset allocation
point of view, though, a benefit is that collectibles offer low correlations with both bonds and stocks. Hence,
advisors may look to collectibles as a way to diversify a portfolio over the long term. Table 12.1 outlines some risks
and benefits of investing in collectibles.

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Table 12.1 | Risks and Benefits of Investing in Collectibles

Risks Benefits

• Illiquid markets • High consumption value (opportunity revenue)

• Pure capital gains play; no income generated • Potentially high price appreciation
• High appraisal, maintenance and other costs • Lower correlations to traditional asset classes
(diversifier)
• High transaction costs
• Risk of frauds and copies • Illiquid markets with inefficiencies
• Rare collectibles skill and knowledge may translate
into large gains

Collectibles provide non-financial benefits relating to consumer values. Art, for example, provides subjective
pleasure to the holder, and valuations of it may vary greatly from one individual to the next. Collectibles can be seen
as a satellite investment complementing core portfolio positions. Advisors are more likely to deal with investors
that come to them with collectibles than to consider collectibles actively as an asset class. Advisors may need to
consider the sale of collectibles when a financial portfolio underperforms or when estate considerations preclude
transmitting a collection to heirs. Professional advice is paramount, then, for appraisal and an orderly, maximum-
value disposition while maintaining the lowest necessary transaction costs.

WHAT ARE THE WAYS TO INVEST IN ALTERNATIVE INVESTMENTS?

In this section we discuss the many ways of investing in alternative investments.

HEDGE FUNDS
The market for hedge funds can be split into (a) funds targeted toward high-net-worth and institutional investors,
and (b) funds and other hedge fund-related products targeted toward the broader individual investor, or “retail”
market.
Hedge funds targeted toward high-net-worth and institutional investors are usually structured as limited
partnerships or trusts, and are issued by way of private placement. Instead of issuing a prospectus, these hedge
funds usually issue an offering memorandum, which is a legal document stating the objectives, risks and terms of
investment involved with a private placement.
In Canada, only accredited investors can invest in these funds. Accredited investors must meet certain minimum
requirements for income or net worth.
For individual investors who do not meet the requirements of an accredited investor, alternative investment
strategies are increasingly being used in hedge funds and hedge-fund products structured as something other than a
private placement. These structures include commodity pools and closed-end funds.
1. Commodity pools: Commodity pools are a special type of mutual fund that can use leverage and engage
in short selling using derivatives. Unlike conventional mutual funds, commodity pools must be sold under a
long-form prospectus. Also, special requirements are imposed on mutual fund salespersons who sell them.
Commodity pools are one way that retail investors can gain access to some hedge fund strategies without
having to meet the requirements of an accredited investor.

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2. Closed-end funds: To avoid mutual fund investment restrictions, a hedge fund may be structured as a closed-
end fund (which means that redemptions by the fund, if any, occur only once a year or even less frequently).
Closed-end funds can be offered to retail investors by prospectus, but are not subject to the investment
restrictions that apply to mutual funds. Closed-end funds are often listed on the TSX, which allows retail
investors access to the fund through the secondary market.

INCORPORATING HEDGE FUNDS INTO A PORTFOLIO

Assessing if and how hedge funds fit into an investor’s portfolio involves the following four main steps:
1. Assess investor suitability in terms of risk/return attitudes, time horizon, liquidity needs and comfort level.
2. If hedge funds are suitable for the investor, assess the relative importance of hedge funds as a percentage of
the total portfolio in terms of immediate needs and future needs.
3. Select specific hedge funds, which includes conducting due diligence and learning about hedge fund managers.
4. Monitor performance over time using specific performance and risk measures (beyond the scope of
this course).

INVESTMENT OBJECTIVES, RISK TOLERANCE AND CONSTRAINTS

The question of investor suitability is important for hedge funds because they are less regulated than traditional
investments. The investor’s goals, objectives and risk tolerance are key factors in determining the suitability of
hedge funds. What does the investor hope to achieve with her portfolio? How much risk is she willing and able to
take to reach this goal?
Hedge funds can be categorized according to level of risk and level of exposure to market risk. In general, hedge
funds that present less market risk tend to be less correlated with existing components of a portfolio and can
diversify away existing market risk. After identifying an investor’s objectives and risk tolerance, an advisor should
consider investment constraints and portfolio constraints to determine if hedge funds are suitable. The main
investment constraints relate to time horizon, liquidity requirements and tax situation, which may affect the
amount allocated to hedge funds within a portfolio.

Time Horizon Long-term time horizons are generally associated with a greater ability to take risk,
but not every investor with a long-term time horizon needs to be exposed to greater
risk. Because market cycles normally last several years, investors with long-term time
horizons can better sustain the ups and downs of the markets than investors with short-
term time horizons. Some hedge funds may not be appropriate for investors with a
short-term time horizon given the potential for significant short-term losses.

Liquidity Requirements Liquidity can be a key factor in an investor’s investment policy, and hedge funds should
be selected accordingly. If investors need to make regular withdrawals, it may be
inappropriate to invest in hedge funds if the remaining portion of the portfolio will not
produce the income required. In general, distributions from hedge funds are erratic
because they focus on capital appreciation in positive market conditions and on capital
protection in negative market conditions, and usually have no income target.

Tax Situation Taxes are an important issue for investors. Tax efficiency is generally not a primary focus
for hedge funds, which may impact their suitability for some investors.

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Portfolio rebalancing Because hedge funds are not liquid securities, it may not be possible or practical
to rebalance a portfolio when needed if it contains hedge funds. The frequency of
rebalancing the portfolio must be matched to the level of liquidity of the overall
portfolio.

ASSET ALLOCATION AND HEDGE FUNDS

Once an investor has identified the rationale for including hedge funds in a portfolio, there are two ways to treat
hedge funds in an asset allocation framework.
1. As a separate asset class in the portfolio.
2. Integrated within existing asset classes in the portfolio.

HEDGE FUNDS AS A SEPARATE ASSET CLASS

Hedge funds can be considered a separate asset class (like equities and fixed income), and a portion of the portfolio
may be allocated to this asset class. In this way, the hedge fund allocation is part of the strategic asset allocation or
investment policy decision. In this top-down approach, hedge funds are considered sufficiently complementary to
and uncorrelated with traditional asset classes to justify a long-term, stable allocation in the portfolio. Typically, the
advisor and investor determine a target allocation for hedge funds and build the allocation to hedge funds gradually
from new cash contributions to the portfolio or by rebalancing existing asset classes into hedge funds.
A typical strategic asset allocation role for hedge funds is as a satellite in a core-satellite configuration. In this
portfolio set-up, the core of the portfolio comprises traditional, stable, lower-volatility asset classes. An example
would be either high-quality actively managed equity and fixed-income assets, or indexed traditional asset
classes. The satellite represents a smaller, specialty-oriented, alpha-generating portion of the portfolio designed
to complement the core components. The satellite is strategically managed to generate the alpha portion of the
portfolio, while the core is managed to provide only the return from exposure to systematic risk.

HEDGE FUNDS WITHIN TRADITIONAL ASSET CLASSES

While hedge fund managers have the ability to invest in a wide variety of securities, many also trade the stocks,
bonds and other securities that a traditional asset manager trades. Thus it might not be appropriate to designate
hedge funds as a separate asset class because the funds are investing in securities that belong to other asset classes.
In this view, hedge funds can be integrated into an asset allocation framework by including them within
the allocation to traditional asset classes of stocks and bonds. In this role, hedge funds represent additional
diversification by market exposure within stocks and bonds, along a continuum from relative value to directional
strategies. Figure 12.1 shows how this within-class diversification of strategies by market exposure can work.

Figure 12.1 | Diversification of Strategies by Market Exposure

Hedge Fund Strategies Traditional Strategies

1 2 3 4
Relative Value Event-Driven Directional Long Only
Low Market Exposure High High

Low Volatility High High

High Probability of Consistent, Absolute Returns Low Low

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Depending on their objectives, risk tolerance and other investing constraints, investors can diversify their equity
market exposure using any of the three hedge fund categories shown in Figure 12.1 by focusing on those funds that
invest in equity securities.
• Relative Value Equity Strategies (low market exposure hedge fund strategy): Equity market neutral.
• Event-Driven Equity Strategies (medium market exposure hedge fund strategy): Merger arbitrage.
• Directional Equity Strategies (high market exposure hedge fund strategy): Long/short equity, global macro,
emerging markets, managed futures and dedicated long or short bias.

Investors can similarly diversify their fixed income market exposure using hedge funds that focus on fixed income
securities.
• Relative Value Fixed Income Strategies (low market exposure hedge fund strategy): Convertible arbitrage and
fixed-income arbitrage.
• Event-Driven Fixed Income Strategies (medium market exposure hedge fund strategy): Distressed securities and
high yield bonds.
• Directional Fixed Income Strategies (high market exposure hedge fund strategy): Global macro, emerging
markets and managed futures.

FACTORS IN HEDGE FUND ALLOCATION DECISIONS

The following are some factors to consider in making the hedge fund allocation decision:

Volatility does not Many advisors assess the volatility characteristics of a hedge fund strategy to determine
equal risk if hedge funds should substitute for stocks, bonds or a combination of these asset
classes. However, the true risks of hedge funds are not reflected solely in their volatility
(standard deviation). Hedge fund risks are multi-dimensional and include risks other than
market risk. This is why investors must adequately analyze hedge funds to determine
their role and weighting in the portfolio.

Investment policy Consider the portfolio’s current asset mix and the investor’s objectives when determining
constraints must be how much to allocate to hedge funds and which asset classes to substitute. Does
taken into account the investor have portfolio constraints relating to liquidity or income requirements?
For example, if investors require a minimum income from their portfolio, it may be
inappropriate to substitute hedge funds for bonds.

Equity substitution Careful substitution of some of the equity component of the portfolio for a relative value
may provide significant equity strategy such as an equity market neutral fund may reduce volatility.
volatility reduction

Bond substitution may Substituting some of the bond component with a fixed-income arbitrage fund may
contribute downside increase absolute returns from the portfolio and help protect it from falling bond prices.
protection

DUE DILIGENCE FOR SELECTING APPROPRIATE HEDGE FUNDS

An advisor should perform a certain amount of due diligence on hedge funds she recommends to clients, even if the
advisor’s firm performs its own due diligence. There are at least 8 key areas for advisors to examine.
1. Fund track record: Advisors should generally consider only those single-strategy hedge funds that have at least
a two-year track record and $25 million under management, and only those funds of hedge funds that have at
least a three-year track record and $100 million under management.

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2. Risk characteristics: Advisors should ensure that their client’s risk tolerance is consistent with the risk
characteristics of the hedge fund. Advisors should also identify different measures of the fund’s risk and risk-
adjusted return, and compare them to the same measures for the fund’s peers.
3. Hedge fund managers: Advisors should examine the experience and reputation of the hedge fund firm and
manager and, if possible, arrange to meet and interview the manager. It is important to focus on the individuals
making the investment decisions rather than the sales representatives trying to sell the fund.
4. Hedge fund features: Advisors should read the marketing material and the term sheet, as well as the prospectus,
offering memorandum or information statement, rather than relying solely on sales presentations. In reading
these materials, advisors should seek to understand the fee and expense structure, the potential use of leverage
and the liquidity terms.
5. Return statistics: Advisors should understand the nature of return statistics published in marketing materials
and know whether they are actual results or pro forma (simulated) results or a mixture of the two.
6. Tax treatment: Advisors should understand the tax implications of the fund.
7. Currency risk: Advisors should know whether the fund is exposed to currency risk, whether the manager intends
to hedge that risk and whether the manager has expertise in hedging currency risk.
8. Operational risk: Advisors should know how big the fund management firm is and whether there are adequate
segregation of duties and sufficient checks and balances in operational controls to limit the chance of
fraudulent activity. Advisors should also identify the fund’s service providers and determine whether they are
reputable.

COMMODITIES
We begin by discussing the various ways of investing in commodities.

FUTURES AND FUTURES OPTIONS

An investor can trade commodities via futures and futures options through one of three means: a standard managed
futures account, a commodity pool or a commodity trading account.

MANAGED FUTURES ACCOUNT

This method involves the opening of an individual futures trading account that is referred to as a managed futures
account. This account is managed on a discretionary basis for the investor by an appropriately trained professional
who is currently licensed by one or more Canadian provincial securities regulators as a commodity trading
manager (CTM). CTM is the correct designation to use for a Canadian-based discretionary futures advisor. The
registration designation commodity trading adviser (CTA) is the comparable licence granted by the U.S. Commodity
Futures Trading Commission, and is often used interchangeably with CTM in the Canadian futures industry. This
interchanging of terms occurs since a number of futures professionals hold both registrations because they often
have clients/investors in both Canada and the U.S.
Managed futures accounts are generally only distributed to individual investors that qualify as exempt or accredited
investors under Canadian provincial securities regulations. In addition, CTMs generally have very strict guidelines
and requirements when opening a managed futures account for a new client.
Each standard managed futures account has unique investment guidelines and restrictions that are consistent with
the individual investor’s commodity investment goals and risk tolerance. The CTM manages the account within
these particular investment parameters. The CTM’s other managed futures account clients may or may not have
comparable investment parameters.

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COMMODITY POOL
The commodity pool is similar to the managed futures account except that the CTM has grouped his managed
futures account clients who have similar investment-related goals and objectives. A commodity pool offers the
CTM all of the benefits and ease of administration associated with managing investment vehicles structured as
funds. Due to economies of scale, investors in a commodity pool have lower investment management expenses and
related administrative fees than those investing in a standard managed futures account.
Commodity pools are regulated under National Instrument (NI) 81-104. This allows commodity pools to be
regulated, with certain exceptions, in the same way as conventional mutual funds. All mutual fund distributors can
sell these products.
Whereas mutual funds may use derivatives for speculation, but only in a non-leveraged manner, NI 81-104 exempts
commodity pools from these restrictions, thereby allowing them to use derivatives in a leveraged manner for
speculation.
In addition, commodity pools are allowed to pay incentive or performance fees to managers as long as the fee is
based on the cumulative total return of the pool since the last fee was paid. NI 81-104 also allows commodity pools
to institute certain redemption restrictions. Under NI 81-104, commodity pools may restrict the rights of holders to
redeem their units for up to six months after the date on which the receipt is issued for the initial prospectus. This is
similar to the lockup provision common among hedge funds. A lockup refers to the amount of time that an investor
is required to keep his or her initial investment in the fund before units can be redeemed.
In exchange for these privileges, and to protect the public, the CSA requires higher proficiency and greater disclosure
than those required of firms and their agents selling conventional mutual funds:
• Salespersons who sell commodity pools must successfully complete the Canadian Securities Course, the
Derivatives Fundamentals Course, or the Chartered Financial Analyst program. This is a higher standard than
that currently required for the sale of conventional mutual funds. (Mutual fund distributors must also have
supervisors in place who have successfully completed the Derivatives Fundamentals Course.)
• Commodity pools must disclose the minimum and maximum levels of leverage experienced by the commodity
pool within a reporting period, calculate their net asset value daily, and provide investors with access to this
information through a toll-free telephone number, acceptance of collect telephone calls or a website.

COMMODITY TRADING ACCOUNT

The commodity trading account permits individual investors to trade and manage their commodity futures portfolio
themselves (without the services of a CTM). It is accordingly very similar in nature to a regular brokerage (margin)
account wherein individual investors manage the assets in the account themselves (i.e., on a non-discretionary
basis). Commodity trading accounts are subject to the same due diligence and account maintenance standards that
are associated with opening a standard managed futures account.

BENEFITS OF USING FUTURES AND FUTURES OPTIONS

Direct Exposure Commodity futures offer the most direct exposure to commodities and commodity price
to Commodities changes; the only other commodity investment vehicle that offers a comparable level of
direct exposure is ownership of the physical commodity. However, commodity futures
do not involve all of the various risks and costs associated with taking physical delivery
of a commodity.

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Diversification Futures contracts exist for virtually all commodities used on a global basis, offering
investors exposure to a unique portfolio of commodities that they can structure to
precisely fit their commodity investment outlook. Sophisticated individual investors
can use them to create and introduce selective commodity exposures to their overall
investment portfolio and thereby achieve maximum diversification benefits.

Liquidity Many futures markets are among the most liquid financial markets in the world.
They allow investors to create, manage and trade their commodity positions without
concern about market liquidity. Indeed, many commodity futures are so liquid that even
medium-sized institutional investors have little difficulty implementing their investment
or trading strategy.

Low Transaction Costs Futures are very economical to trade. They generally have the lowest transaction costs
(calculated as a percentage of trade value) when compared with costs associated with
investment in all other types of commodity-related vehicles.

Cost savings for the investor show up in several ways. The high level of liquidity leads to smoother price
movements, and for larger trade sizes, the investor gets better trade execution on both the purchase and sale price
(smaller bid-ask spreads). The high volume of transactions also leads to lower per trade exchange-related fees as
well as smaller transaction commissions charged by futures commission merchants.

Price Determination The liquidity associated with commodity futures leads to an extremely rapid price-
setting environment. This level of price determination is at least on par with large
cap stocks on the world’s premier stock exchanges. Commodity markets respond
instantaneously to new information affecting the price and changes in investor demand.

Transparency Investment in commodity futures offers complete transparency on a daily or even real-
time basis. Transparency has always been a hallmark of the commodities market because
of the daily mark-to-market valuations required to properly administer margin-based
investing. The transparency of futures-related investment vehicles is beneficial to the
investor and far better than that afforded in some other types of commodity-related
investment vehicles, such as actively managed mutual funds and commodity funds, as
well as hedge funds.

RISKS AND DISADVANTAGES OF USING FUTURES AND FUTURES OPTIONS

Excessive Leverage The opportunity to invest in futures on a highly margined basis can be appealing to
investors but results in a risk to investors far greater than the leveraged risk associated
with almost all other forms of investing. For example, on a fully leveraged/margined
basis, an investor can potentially lose the entire margin deposit—and more—with just
a 2% to 5% movement of the commodity future’s price in the wrong direction.

Lack of Diversification Investing in futures contracts of only a few commodities carries the same risk associated
with investing in the equities of a very limited number of companies, specifically a lack
of portfolio diversification. This focus often leads directly into a concentrated portfolio,
which increases the investor’s overall risk if the commodity price moves adversely.

The lack of diversification, along with the leverage available to futures investors, can be financially devastating for
the investor. Individual investors are generally best advised not to make futures investments in a limited number of
commodities because of these two risks. The way to minimize risk is to consider investment in a passively managed

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futures fund that replicates a broad-based commodity index, a well-diversified commodity mutual fund or a
managed account that has appropriately designed investment guidelines and restrictions.

ACCESSING COMMODITIES USING EXCHANGE-TRADED FUNDS

Exchange-traded funds (ETFs) are a simple way to access the commodities market.
An ETF represents shares in a basket of securities, which may be indexes, stocks, bonds or commodities. An ETF
is publicly listed on a stock exchange and combines certain features of mutual funds and closed-end funds. Their
valuation is similar to a mutual fund’s, in that ETFs have a net asset value (NAV). They are also similar to closed-end
funds because they can be purchased or sold throughout the trading day at the current bid or ask price.
Commodity-related ETFs are categorized into the following major types:
• Index ETFs
• Commodity ETFs
• Leveraged ETFs

INDEX ETFS
Index ETFs attempt to passively replicate the performance of an index with a commodity-based theme. The index
might consist of a basket of industrial mining stocks or the index might hold a basket of physical commodities.

COMMODITY ETFS
Commodity ETFs are designed to provide direct exposure to the price movements of the underlying asset. This is
achieved through one of two ways: a) Physical ownership or b) Synthetic replication.
1. Physical ownership: The ETF actually has stores of the commodity it owns in vaults or warehouses. Shares in
the ETF represent fractional interest in the trust that has ownership of these stores. The most popular ETF of
this type is the SPDR Gold Trust (symbol: GLD). Their gold is held in London, England in the vaults of the fund’s
custodian.
2. Synthetic Replication: The ETF has no physical holdings of the commodity. Instead, the fund holds a
combination of futures, swaps and options that tracks the commodity price movement. Periodically the fund
must rollover its expiring contracts.

LEVERAGED ETFS
These types of ETFs are designed to magnify the returns over those of a standard, or unleveraged, ETF. Leveraged
ETFs are structured to provide daily returns that are anywhere from 1.5 to 3.0 times the rate of return on the
(unleveraged) reference portfolio. In addition to a predetermined leverage factor, some ETFs are also structured
to provide rates of return that are opposite to the current market return. These are inverse ETFs, and can be either
leveraged or unleveraged.
The investment management techniques for leveraged ETFs are sophisticated and rely heavily on the use of
derivatives. Due to their leveraged nature, these particular types of ETFs can be risky and often have very volatile
returns.

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BENEFITS OF INVESTING IN ETFS WITH COMMODITY EXPOSURE

Ease of use An investor can quickly get as much or as little commodity exposure in one or more
commodity markets in the click of a computer mouse. All of the details that an
individual investor at one time had to address to get commodity exposure (currency
translation, custodial arrangements, leverage facilities, etc.) are now taken care of by
the ETF sponsor. Ease of use also simplifies the investor’s asset allocation and portfolio
rebalancing process.

Low Expense Ratios Index tracking and physical ownership commodity ETFs generally have lower expense
ratios than most mutual funds. ETFs that use derivatives are more expensive but their
MERs are still on par with the average domestic equity mutual fund.

Low Transaction Costs The cost (brokerage commission) to buy and sell an ETF is generally far less than one
would pay to buy and sell a similar mutual fund. Even in situations where investors
purchase mutual funds directly from the fund manager and pay no load, ETFs can still be
very competitive on a net of fees and commissions basis.

Stock-like Features ETFs offer many of the same advantages and features associated with investment in
exchange-listed equities:
1. Short selling: Although it is not generally recommended for the majority of
individual investors, ETFs can be sold short. This flexibility may be useful if the
investor feels that the portfolio can use some protection from expected falling
commodity markets.
2. Limit orders: Investors can use limit orders to assist with the purchase or sale of
ETFs. The standards and features of limit orders for ETFs are identical to the ones
that apply to equities.
3. Margin purchases: Investors with margin accounts can use these borrowing facilities
to purchase ETFs partly financed with brokerage funds.
4. Availability of Options: ETF options are structured in a similar manner to the more
common options on equities with puts and calls available at various strike prices
and expiry dates.
5. Transparency: Transparency is the ability of the investor to obtain the fund’s specific
security holdings and transactions on a timely basis. Most commodity ETFs offer
complete daily transparency.

RISKS AND DISADVANTAGES OF INVESTING IN ETFS

Lack of Diversification The customization and narrowness of the investment mandates and objectives of ETFs
generally lead to the creation of some ETFs with concentrated exposure to a single
market sector or commodity.

Temptation to Trade The stock-like characteristics associated with ETFs have led many investors to use ETFs
Excessively as short-term trading vehicles to try and time the market. When viewed and used in this
manner, ETFs usually increase the investors’ risk because of the high commission costs
involved or the employment of incorrect trading strategies.

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Currency Risk Commodity tracking ETFs may have currency risk for Canadian investors. Most world
commodities are traded in US dollar terms. A tracking ETF may or may not choose to
hedge out this currency risk.

Excessive Leverage The ability to purchase an ETF on margin and sell short adds the risk of increasing the
amount of leverage in the investor’s overall investment portfolio.

Basis Risk Some commodity ETFs track their underlying assets using futures, swaps or other
derivative combinations. The price of the ETF may not fully track the net asset value of
the ETF. In periods of high commodity price volatility, the price of the ETF and the net
asset value of the reference commodity can diverge and remain this way for some time.
There is also a high degree of basis risk from holding leveraged ETFs over long time
periods. As many leveraged funds promise a multiple on the daily return of a commodity,
these ETFs must daily reset their derivative positions. Long leveraged ETFs typically add
net long derivative positions when the tracking commodity rises in price or reduce net
long derivative positions when the tracking commodity falls. The effect over time in a
volatile commodity market is to reduce the return of the ETF to less than that of the
leverage factor. Thus a highly volatile commodity market might see a +6% return over a
month. A 2x leveraged ETF tracking that commodity might only return 9% in the same
period depending on the severity of the underlying price movements.

Credit Risk Swap-based ETFs have indirect credit risk exposure. Counterparties write the swaps
used to track commodity price movements. If the counterparty is unable to meet its
obligations because of financial difficulties, the ETF NAV cannot be calculated. The ETF
will trade at a large premium to its NAV until the ETF sponsor can find a replacement
counterparty or the original counterparty can resume its role.

Roll Yield Risk Investors can incur losses on futures-based ETFs simply from the passage of time on
front month contracts. Commodity markets can be in a state where the front month
futures contract is trading at a premium to the spot market price. This is the roll yield.
As time approaches contract expiry, the price of the front month contract falls towards
the spot market price, assuming no other market condition changes. The front month
contract must equal the spot price when the contract expires. Theoretically an ETF
holding the front month contract will incur the loss of the roll yield unless the market
factors in higher prices before the contract expiry.

PHYSICAL COMMODITIES
Investors can take physical delivery of the commodity after purchase. This form of commodity-related investment
can involve numerous logistical and other related challenges and expenses. Due to the bulk nature of physical
commodities, very few investors invest in and take delivery of any commodities other than precious metals. The
risks, challenges and costs associated with physical purchasing, holding and selling nearly any commodity (other
than precious metals) tend to outweigh the benefits, as described in more detail below.
Part of the allure of holding precious metals in physical form is attributable to investors’ concern that other forms
of precious metals investment do not involve direct claims on the commodity itself. Historically this was true,
however, some newer commodity products have diminished these concerns somewhat and therefore reduced the
amount of interest in holding precious metals in physical form.

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BENEFITS OF INVESTING IN PHYSICAL COMMODITIES

Direct Exposure Taking physical delivery allows the investor to directly experience the price changes of
the particular commodity. For bulk commodities such as base metals and grains, this
market price exposure is direct only if the investor holds a sufficiently large amount of
the commodity so that its bid price would equal the wholesale or institutional market
price. With holdings of smaller size, the bid price would normally be expected to be
lower than the prices for trades executed on the various commodity futures exchanges.

RISKS AND DISADVANTAGES OF INVESTING IN PHYSICAL COMMODITIES

Large Minimum Except for the members of the precious metals group, commodities can only be
Investment purchased in minimum physical lot sizes that are well beyond the financial capabilities
of the average individual investor. Purchases below minimum lot size are not generally
attractive as a form of commodity investment, for a number of reasons. First, the per
unit purchase price is likely to be at a premium to the commodity exchange market
price, because bulk commodities normally cost more on a per unit basis when purchased
in small amounts. Second, all of the costs (discussed below) associated with transporting
and storing bulk commodities will rise on a per unit basis as a result of the small volume
amount. This large minimum investment effectively makes investment in commodities
on a physical basis cost-prohibitive for most individual investors.

Transportation Costs In the case of a bulk commodity, the investor will have to rent or lease the appropriate
transportation vehicles or services such as a semitrailer or rail car to physically move
the commodity. The expenses associated with transporting the commodity from the
point of delivery stipulated in the futures contract to the location of the investor’s
storage facilities is a cost to the buyer, and normally too expensive to be practical for the
individual investor to undertake.

Storage Costs Especially in the case of many agricultural or other “soft” commodities, the purchase
must be stored in a secure warehouse or similar facility that provides appropriate
protection from weather and theft. Most individual investors do not typically own
suitable storage or handling facilities and so must incur the costs of renting, leasing or
purchasing them. These costs are the responsibility of the investor.

Insurance Costs Depending on the particular commodity, it is usually prudent for the investor to
purchase insurance to protect the physical commodity asset against the standard risks
associated with transportation, handling and storage and risks varying from weather-
related damage to theft. Again, these insurance premiums are a cost for the commodity
investor.

Assaying Costs Investors holding precious metals in physical form are often required to have assays,
(Precious Metals) measurements to determine the weight and purity, performed on their holdings
before they sell them. These assays are generally required by the buyer and paid for by
the seller.

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HOW DO COMMODITY PRODUCERS MANAGE FINANCIAL RISK?

Financial risk management is the practice of analyzing how a company responds to financial market risks, such as
rising interest rates, fluctuating foreign currency earnings, etc. There are three operational variables that determine a
firm’s profitability. These are also the operational variables affected by financial risk management:
1. The quantity of commodity produced;
2. The cost of production;
3. The selling price of the commodity.

Thus the firm’s profitability depends on more than just the commodity’s market price. The firm should strive to
minimize costs and maximize production and selling price. If it cannot control anyone of or all three variables, the
firm will lag behind in its stock returns compared to the commodity’s return. The firm can get the maximum benefit
on the first two factors by utilizing economies of scale. For economies of scale, this means designing big facilities to
produce maximum quantities and to drive down the unit cost of production, thereby maximizing marginal profit.
The lowest cost of production gives companies the opportunity to make the largest margins when commodity
prices are high. It also improves the chances of the company’s survival when commodity prices are low for extended
periods of time.
In maximizing the commodity’s selling price, the firm must decide to sell future production at either the prevailing
market price at that time or employ some type of hedge strategy to “lock in” a price. The heart of financial risk
management for a commodity-producing firm is its product price hedging strategy.
A commodity-producing company can hedge none, some or all of its future sales volumes. Some companies decide
not to hedge any of their future production. Companies generally do not hedge because they believe:
• future prices will be higher than current prices, or
• future product price risk will make them more competitive and profitable over a certain time horizon.

The decision not to hedge any production can lead to higher profitability if future spot prices are indeed greater
than the price at which the hedge would have been executed. However, financial results for the firm are more
volatile than its competitors who do employ hedging strategies. Most banks that lend to newer or smaller resource
companies normally require the borrower to implement a commodity price-hedging program in order to reduce
the bank’s default risk on the loan. In turn, the borrower generally realizes the benefit of a lower interest rate on the
bank loan because of the lower credit risk associated with its (hedged) operation.
Other companies employ a tactical hedging strategy, meaning that they decide to hedge part of their future
production or hedge it for only a certain period of time. One might call this strategy “hedging your bet by only
hedging part of your exposure.” Such a strategy can easily turn into a speculative activity, since only part of the total
production is hedged, and the hedge is applied and then taken off for various periods of time.
For a company that has fully hedged its production, financial performance is not be impacted by movements in
the spot price of the commodity, since the company’s financial results (sales) are not affected by the spot price
movements. During a period of rising commodity prices, the company’s share price would not likely rise as much as
an unhedged competitor’s share price.

THE OPERATIONAL NATURE OF THE COMPANY

A pure play refers to a commodity-producing company’s operation whose revenues are 100% dependent on the
production of the raw commodity itself. Theoretically the stock return on a pure play would have a high correlation
with the return on the commodity price. But in practice a pure play equity investment is rare for a couple of reasons.

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First, in some commodity sectors, such as precious metals and base metals mining, it can be difficult to find
companies whose deposits and production activities are entirely concentrated in one commodity. Most deposits
have other minerals mixed in with the primary mineral. This happens so frequently in mining that it is standard
financial reporting practice for the revenue realized from the sale of these by-product metals to be accounted for
as a credit to, or a reduction in, the total cost of mining the targeted mineral. On occasion, by-product revenues are
high enough to more than completely offset the total extraction costs and result in a negative operating cost for
each ounce of mined precious metal. Some companies’ financial performance might actually be more dependent
upon the combined value of the by-product revenues than upon the price of the primary precious metal itself.
Second, a company becomes less of a pure play the more it becomes vertically integrated. One financial reason for
a company to become vertically integrated is to smooth out its operating margins over time by having operations
in more than one step in the value-added chain. Let’s say that ABC Co. is a good example of a vertically integrated
company in the oil and gas sector. ABC Co. sells production from all four major steps in the oil and gas industry:
1. Oil and gas exploration and development
2. Oil refining
3. Oil and gas storage, transportation and pipelining
4. Wholesale, industrial and retail sales and distribution

ABC Co. earns higher operating margins the further down the value-added chain it goes. The operating margins for
each step vary in magnitude and seldom have matching cycles. Competitive pressures and therefore margins in
retail distribution are often not in sync with the margins earned by successfully exploring for and discovering crude
oil deposits.
In contrast, let’s say XYZ Co. is solely focused on exploration and production. All of its expenditures and assets are
related to developing oil and gas resources that are sold and injected into a pipeline operated by a third party. The
vast majority of small oil and gas companies, and most medium-sized oil and gas companies as well, are set up
in this way. Their margins are entirely dependent on two factors: the cost of finding and extracting the oil and gas
resources and the price at which the raw oil and gas is sold.
XYZ Co. would normally be considered more of a pure play in the oil and gas industry than would a fully integrated
oil and gas producer such as ABC Co. One would expect XYZ Co.’ share price performance to be more closely
correlated with the market price of crude oil and natural gas because market price is one of the two main factors
driving its margins. Meanwhile, one would expect ABC Co.’s share price performance to be less correlated with the
market price of crude oil because its overall corporate profitability is a combination of margins earned in the four
steps of the oil and gas business.

COMPANY FINANCIAL STRUCTURE

The final reason for low correlation between commodity and equity returns is a result of a firm’s capital structure.
Every company in any business has its own unique operating leverage (how fixed costs versus variable costs are
used in its operating structure) and financial leverage (how borrowed money is used to fund operations). Once set,
neither factor can be changed easily in response to short-term changes in the markets.
Although higher leverage, operating or financial or both, has the ability to increase or magnify financial results in
strong commodity markets, it has the opposite effect when commodity prices and demand are declining. In down
markets, companies that are highly leveraged have a greater chance of bankruptcy as their ability to cover fixed
costs and debt payments declines dramatically.
Operating and financial leverage will increase the sensitivity of the company’s financial results (and accordingly its
share price performance) to changes in the underlying commodity’s unit price. Pure plays in the same commodity
can have substantially different financial results and share price movements over the same time period simply
because of the relative differences among companies’ operating leverage and financial leverage.

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WHAT ARE THE WAYS TO INVEST IN REAL ESTATE?

ACCESSING REAL ESTATE USING REAL ESTATE AND MORTGAGE

SYNDICATIONS
Real estate syndications and mortgage syndications are funds that offer opportunities to invest in specific projects,
real estate portfolios or mortgage portfolios that are not readily available to individual investors. Depending on the
specific offering, the appeal of these investments is the potential for above average returns and tax deferrals.
However, the majority of real estate and mortgage syndications sold as prospectus-exempt issues are speculative
and illiquid. Wealth advisors must consider these caveats when determining whether to recommend a real estate or
mortgage syndication to a specific client. The regulators’ view is that a wealth advisor’s recommendation to a client
must adhere to the following three-stage process:
1. Use due diligence to know the product and know your client.
2. Assess suitability by determining whether a particular investment product is an appropriate match for a
particular client.
3. If an investment product is suitable for a particular client, you may recommend the investment product but
you must make the client aware of material factors, both positive and negative, associated with the investment
product.

Real estate investments sold under prospectus exemptions are typically offered in the form of limited partnerships.
Their key advantage is that the interest and other income earned by the limited partnerships can flow through
directly to the limited partners to be taxed at their lower tax rates.
Virtually all real estate syndications need to meet minimum investment requirements in order to be prospectus-
exempt in the jurisdictions the syndications are offered.
Generally, mortgage syndications are structured as mortgage investment corporations. For tax purposes, income flows
through to investors to be taxed in their hands (or not subject to tax if paid into RRSPs or similar tax-deferred plans
and accounts). Mortgage syndications can be set up to pay a fixed monthly amount or an amount tied in part to the
yield on a specific government bond. Mortgage syndications can also be structured so that investors receive monthly
payments equal to their share of the income received by the mortgage investment corporation on the pool of assets.
A key element of both real estate syndications and mortgage syndications is the use of leverage. Some offerings
include optional loan arrangements for investors who don’t have all the cash necessary for the minimum
investment, which in turn increases risk for those specific investors.

TYPES OF REAL ESTATE SYNDICATIONS

Similar to equity mutual funds, real estate syndications also come in various different types. Some of the more
common variations include the following:
• Land banking
• Brownfield development
• Redevelopment projects
• Purchasing mature properties
• Purchasing distressed properties or mortgages in default
• Mortgage syndications
• Mortgage fund on a specific project
• Blind pools

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LAND BANKING
Land banking usually involves the purchase of a tract of raw land outside an urban area with the expectation that
the urban area will expand because of economic growth in the region. This type of model requires a significant
amount of capital and usually includes a reserve to cover expenses for several years, until a portion of the land can
be sold. The time horizon for land bank projects can range from as little as five years to as long as 20 years. The
objective is capital appreciation.

BROWNFIELD DEVELOPMENT
A brownfield development is the redevelopment of an abandoned or underused commercial or industrial property,
generally in an urban community. An example of this would be the purchase of an abandoned manufacturing facility
and its conversion into, or replacement with, residential housing. Another example would be the redevelopment of
what was once an area of stockyards and packing plants into a mix of commercial and residential properties. These
types of projects also require a significant amount of capital relative to the cost of the property, and have capital
appreciation as their objective.

REDEVELOPMENT PROJECTS
Redevelopment projects involve purchasing income-producing properties with the longer term objective of
redeveloping the properties and increasing the income they generate. The objective is to produce some income
near-term and higher income as the properties are replaced with higher value buildings. Generally, the partnerships
use debt secured by the properties purchased to finance the redevelopment.

PURCHASING MATURE PROPERTIES

A partnership is formed to purchase a specific income-producing property or properties. The objective is to increase
income by improving the properties, and to benefit from rising rents, decreasing costs or both. Another objective
is for management to refinance the properties as they appreciate in value and distribute some portion of the
refinanced amount to investors in a tax-effective manner, or alternatively sell them and distribute the proceeds.

PURCHASING DISTRESSED PROPERTIES OR MORTGAGES IN DEFAULT

A partnership is formed for the purpose of buying homes sold under power of sale or foreclosure at a deep discount
to market value, or buying defaulted mortgages at a deep discount to face value. The intention is to acquire the
properties that secure the mortgages through foreclosure. The objective is to refurbish the properties, rent them and
sell them several years later, once real estate prices increase.

MORTGAGE SYNDICATIONS
Mortgage syndications offered as exempt investment products invest in higher risk mortgages that do not meet
the criteria established by traditional institutional lenders, such as banks. Most often, these syndications provide
financing for construction or land acquisition. Often, the size of the loan is a percentage of the estimated value of
the project at completion. Rates charged are generally much higher than widely published mortgage rates, typically
reflecting the risk level.

MORTGAGE FUND ON A SPECIFIC PROJECT

Typically, the purpose of such a mortgage fund is to finance the acquisition and redevelopment of a specific
property. While the loan is secured by a lien on the specific property, the value of the property may be less than the
value of the mortgage. Payment of interest and repayment of principal will depend on whether the property, once
redeveloped, can produce enough income to cover interest and principal payments, and on whether the property
appreciates in value.

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BLIND POOLS
Blind pool investors are presented with information about the general type of real estate, or real-estate securities
that the pool management intends to invest in. However, the exact specifications of the investments are unknown
and unavailable at the time that the investor commits to the blind pool.

EVALUATING THE RISKS AND BENEFITS OF REAL ESTATE AND MORTGAGE

SYNDICATIONS
Many factors affect the value of real estate, including the following:

General business Real estate prices tend to move with the general economy, performing well when the
activity economy expands and declining when the economy contracts. Other factors that affect
all real estate investments include interest rates and the availability of mortgage loans.

Expected inflation Real estate prices generally tend to provide good returns when inflation is increasing
and inflationary expectations are high. Conversely, prices may decline in a deflationary
environment.

Demographics The age structure of the population is an important determinant of the type of
properties demanded by consumers and other users. For example, an area experiencing
high rates of immigration will see a rising demand for housing resulting in higher prices;
whereas a city dependent largely on a single industry that is contracting will likely see a
displacement of workers and a supply of housing that far exceeds demand, driving prices
lower.

Location The location of a specific property is generally considered the most important factor in
evaluating a property.

Regulation and Zoning laws and regulations vary from jurisdiction to jurisdiction and have a significant
zoning laws impact on valuation. For example, demand for rental properties as investments would
generally be higher in jurisdictions that tend to protect and expand the landlord’s rights
in the landlord–tenant legislation.

RISK FACTORS
Typically, the risk factor section of a product offering memorandum for a real estate investment is several pages
long. The information varies based on the specific facts of the property or properties in question. In general, the risk
factor section may contain statements indicating each of the following:
• There is no guarantee that an investment in units will be successful and that the objective of earning a profit on
the eventual sale of the property will be achieved. The success of the partnership in these objectives will depend
on the efforts and abilities of the management and external factors, including general economic conditions and
the development of residential and commercial real estate markets in the vicinity of the property.
• Risks of real estate ownership include items such as:
• risk that depends on the nature of the property
• the highly competitive nature of the real estate industry
• changes in general economic conditions effecting the availability and cost of mortgage funds
• changes in local conditions, such as the supply of commercial space and demand for residential space

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• changes in government regulation, such as zoning, taxation and environmental laws and regulation
• changes in interest rates
• The investment product offered is speculative in nature.
• Real estate investments are illiquid.
• The costs of holding real estate are considerable and, in a recessionary climate, costs may not be offset by
income. If it becomes necessary to sell some or all of the property, the price received may be low.
• Conflicts of interest are appropriately disclosed.

The risk factor section will also disclose risks specific to the offering, such as the following:
• Currency risk may exist if the funds raised are in Canadian dollars and the properties to be purchased are in the
United States or in another foreign jurisdiction.
• The examples of historical returns on other projects noted in the offering memorandum were based on a
different business model, on lands located in another jurisdiction.
• Future profits will depend on whether the major urban centres in the area will expand and whether the property
will become attractive to developers.
• The management’s level of experience, in the market where the property is located, is appropriately disclosed.
• A bubble in real estate prices, in the market where the property is located, is possible.
• If the partnership defaults on any debt, the creditors will have potential recourse against the property.

HOW REAL ESTATE AND MORTGAGE SYNDICATIONS FIT INTO

A CLIENT PORTFOLIO
Adding real estate to a traditional portfolio composed of cash plus fixed-income and equity securities provides
an additional measure of diversification. The returns on real estate investments are generally uncorrelated with
traditional securities, such as equities and fixed-income securities. In fact, real estate has been widely regarded as a
hedge against inflation because its returns are positively correlated with the rate of inflation. This is in contrast to
fixed-income securities and non-resource equities, which have historically shown to be negatively correlated with
inflation.
However, real estate syndications and mortgage syndications are generally speculative securities. They are not
traditional real estate investments or National Housing Act (NHA) mortgages. They are high-risk and often highly
leveraged. They should not be considered as a means of lowering portfolio volatility.

ACCESSING REAL ESTATE USING MORTGAGE-BACKED SECURITIES

Mortgage-backed securities (MBS) are another class of real estate investment. MBSs were previously discussed in
Chapter 8. In this section, we discuss two types of securities related to MBSs:
• Collateralized mortgage obligations (CMOs)
• Stripped mortgage-backed securities (Stripped MBSs)

COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS)

A collateralized mortgage obligation (CMO) is a mortgage-backed bond that separates mortgage pools into
staggered maturity groups (tranches) that reallocate the interest and principal payments. Each tranche is sold as a
separate security and has a different claim on the underlying cash flow. Tranches vary from those that receive the
capital first to those that receive the capital only at the end. They all receive interest on the capital remaining in
their respective tranche.

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For example, a fast-pay tranche might receive all the principal payments from the MBS until its investment has been
recouped, while the other tranches receive only interest payments. Once the fast-pay tranche has been paid back,
the second tranche begins to receive principal payments until it is repaid, and so on.
The tranche that has its capital paid last receives a more predictable income flow. This tranche also knows how long
it will be receiving a particular interest rate. The tranche that is paid capital first faces a much higher reinvestment
risk.

STRIPPED MBS (SMBS)

Stripped MBSs divide the cash flows from the underlying mortgage security into two or more new securities.
Stripped securities can be partially stripped, so that each investor receives a combination of principal and interest
payments, or they can be completely stripped. Strips can be structured to be interest-only (IO, receiving only
interest from the underlying securities) or principal-only (PO, receiving only the principal payments). Both IOs and
POs are subject to great price volatility in a market of changing mortgage rates.
If mortgage rates drop, the price of the PO increases, due to rapid prepayment of principal. The price of the IO
decreases because the rapid prepayment rate reduces the interest payment stream so severely that the value falls
almost to zero. In fact, the investor could receive less money than originally invested. The stripped MBS is obviously
not an investment for a conservative-minded retiree.
Conversely, if mortgage rates rise, the price of the PO decreases. This is because the repayment of principal lies
further in the future and the increasing discount rate reduces the security’s present value. The price of the IO strip
may increase or decrease. The payment stream is more valuable as the prepayment rate is reduced. However,
increases in the discount rate will decrease the present value of the income stream.

ACCESSING REAL ESTATE USING REAL ESTATE INVESTMENT TRUSTS

Real estate investment trusts (REITs) consolidate the capital of a large number of investors to invest in and manage
a diversified real estate portfolio. Investors participate by buying “units” in the trust. Investors receive net returns
generated by the pool, pro rata to their unit proportion. REITs allow investors to invest in commercial and industrial
real estate previously available only to corporate or more affluent and sophisticated investors.
To qualify as a REIT, a company must have most of its assets and income tied to real estate investments. REITs
are typically structured as mutual fund trusts and may be either open-ended or closed-ended. If they meet the
standards set out under the Income Tax Act, REITs may qualify as registered investments for RRSPs and RRIFs.
REITs can be either privately offered to prospectus-exempt investors through an offering memorandum or publically
offered to any investor on an exchange, issued through a prospectus offering. The terms of privately offered REIT
redemptions vary by company and may be limited in nature.
REITs have been successful in the recent past. The following are some of the main features of REITs and REIT
investing:
• Canadian REITs offer tax efficiency because they flow profits back to investors to be taxed in their hands (under
individual tax rates lower than at the trust level).
• REITs will tend to be more correlated to equities than to bonds, as their sensitivity to macroeconomic factors
and overall economic health is similar to stocks.
• From an asset allocation point of view, REITs tend to be construed as a high-yield bond or equity substitute.
Their liquidity makes them less stable than physical real estate investing and contributes to making their market
value significantly more volatile.
• Investors contemplating the addition of REITs to retail portfolios should be mindful of the real estate already
present in net worth and should consider the market cycle typical of this asset category.

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BENEFITS OF REITs
Professional REITs allow the investor the opportunity to have her properties managed by a
Management professional real estate team that knows the industry, understands the business and
can take advantage of opportunities thanks to its ability to raise funds from the capital
markets.

Liquidity Publically traded REITs provide exposure to real estate – real assets with tangible value
and reliable income streams – in highly liquid, marketable securities that have daily
price quotations. However, investors should determine the liquidity of any particular
REIT before investing, since some, especially the more specialized REITs, have thin
trading volumes, despite being exchange traded.

Limitation of Direct real estate investors may be exposed to liability beyond their initial investment
Personal Risk because of the use of leverage. REIT investor’s liability is limited to the cost of the REIT
units.

Portfolio Diversification REITs offer investors an opportunity to gain exposure to a diversified portfolio of real
and Diversification estate properties with a relatively small investment. As well, REITs offer some portfolio
within the Real Estate diversification as they tend to have relatively low correlations with overall stock index
Segment averages.

Conservative Leverage REIT managers generally minimize risk by avoiding real estate development and
investing primarily in established income producing properties. To reduce the danger
of incurring too much debt, most REITs limit the extent of leverage to 50% to 60%.
Leverage ratios tend to be significantly higher in direct real estate.

Tax Efficiency Canadian REITs offer tax efficiency because they flow profits back to investors to be
taxed in their hands.

Essentially, Canadian REITs offer the following tax benefits:

1. Pre-tax income flows through to investors (income is taxed at the investor’s lower rate),
2. Investors can defer tax until the units are sold at which point the tax deferred portion is used to lower the
adjusted cost base of the REIT.

EXAMPLE
Reit Taxation
An investor purchases Canadian REIT units at $20 per unit in Year 1 and receives per unit distributions of $2 per
unit for the next 3 years of which 60% can be tax deferred. The Units are sold in Year 3 for $22.00.

Distribution Income (for tax purposes) Adjusted Cost Base

per unit per unit per unit
Year One $2.00 $0.80 $20.00 – $1.20 = $18.80
Year Two $2.00 $0.80 $18.80 – $1.20 = $17.60
Year Three $2.00 $0.80 $17.60 – $1.20 = $16.40
Sale Realized capital gain =
$22.00 – $16.40 = $5.60

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The tax advantages may vary according to an individual’s personal tax situation and where the REIT is held.
If, for example, the REIT is held in an RRSP, significant tax benefits accrue.

Stable Yield Because rental income is fairly stable, REITs generally yield stable returns but may lack
the potential for large capital gains possible with other equities. As with any investment,
it may be necessary to accept lower yields to ensure the REIT consists of a high-quality
portfolio.

RISKS
Volatility of Real REITs face many of the risks typical of real estate investments related to interest rate
Estate Market cycles, the quality of properties, rental markets, tenant leases, debt financing, natural
disasters and liquidity.

Poor Quality of Although professional management is cited as a benefit of REITs, investors still need to
Management check the qualifications and experience of the REIT management team. Investors are just
as susceptible to management ineptitude as with any other pooled investment.

WHAT ARE THE WAYS TO INVEST IN PRIVATE EQUITY?

Investors in private equity, whether institutional or individual, participate through three product structures:
• Direct investing
• Direct funds
• Funds of funds

DIRECT INVESTING
Direct investing provides the most control of any form of private equity financing. The investor is fully responsible
for the investment selection and exit process. The investor enters into a financing deal directly with a counterparty.
Doing so entails identifying suitable investment targets, conducting rigorous due diligence on selected targets
and analyzing the financial and business situation and outlook of the target firm, as well as modeling post-deal
economics and issuing a business plan. This approach requires highly skilled and specialized teams with merger and
acquisition, corporate finance, legal and investment banking experience. A direct investor is fully liable for any losses
triggered by the investment. Consequently, direct investing is usually the domain of only the wealthiest clients.
Another type of direct investing is co-investment. In this case, an investor partners directly with a private equity
firm (technically, the investor invests directly in a company controlled by the private equity firm). The benefits of
co-investing compared with direct investing can be substantial and include the sharing of experience and expertise,
reduced capital commitments, access to bigger deals for a given asset commitment, and learning by working with
seasoned experts.

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DIRECT FUNDS
A more common alternative to direct investing is for investors to join a direct fund as limited partners. The fund
will invest in 10 to 30 transactions and will offer much better diversification than direct investing does. Direct
funds require much lower capital commitments from investors than direct investments do. If the partnership’s
investments prove successful, the general partner will likely call on the limited partners in subsequent partnership
offerings. Moreover, investors do not need to provide private equity investment skill; this is the general partner’s
role. The skills required of the investor are selecting and securing the best general partners.

FUND OF FUNDS
An increasingly common alternative is for investors to participate in a fund of funds. Fund of funds represent
approximately one-third of all worldwide private equity investing capital. Fund of funds typically invest in up to 20
funds (with each fund itself investing in 10 to 30 direct investments), thus accessing hundreds of investments for full
diversification. Such diversification means a wider spreading of investment risks. Capital commitments for investors
are even smaller than those required for direct funds or direct investments. Fund of funds generally constitute the
lower risk/lower return variant of private equity investing.

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 CHAPTER 12 | ANALYSIS OF NON-CONVENTIONAL ASSET CLASSES AND THEIR STRUCTURES 12 • 33

SUMMARY
By the end of this chapter, you will be able to:
1. Explain what an alternative investment is.
• Alternative investments are asset classes that are different from the traditional three broad asset classes of
equities, bonds and cash.

2. Describe hedge fund risk drivers.

• First-order risk (or directional risk) refers to exposure to changes in the general direction of equity, fixed-
income, currency and commodity markets.
• Second-order risks include liquidity, leverage, deal-break, default, counterparty, trading, concentration, pricing
model, trading model risks.
• Operational risk (or business risk) relates to the hedge fund as a business entity and stems from the fact that
many hedge funds are small, newly created businesses that depend on one or more high-profile managers for
their success.

3. Explain criteria for hedge fund investment.

• Assessing if and how hedge funds fit into an investor’s portfolio involves the following four main steps:
« Assess investor suitability in terms of risk/return attitudes, time horizon, liquidity needs and comfort level.
« If hedge funds are suitable for the investor, assess the relative importance of hedge funds as a percentage of
the total portfolio in terms of immediate needs and future needs.
« Select specific hedge funds, which includes conducting due diligence and learning about hedge fund
managers.
« Monitor performance over time using specific performance and risk measures (beyond the scope of
this course).

4. Describe how commodities may fit into an investment portfolio.

• As commodities produced high returns with low correlation to other assets, the Ibbotson study found that
including commodities in a strategic asset allocation produced a superior efficient frontier at any level of risk
relative to returns, compared to when commodities were excluded.

5. Compare the different methods of investing in commodities.

• An investor can trade commodities via futures and futures options through one of three means: a standard
managed futures account, a commodity pool or a commodity trading account.
« Managed futures account: this account is managed on a discretionary basis for the investor by an
appropriately trained professional who is currently licensed by one or more Canadian provincial securities
regulators as a commodity trading manager (CTM).
« Commodity pool: the commodity pool is similar to the managed futures account except that the CTM has
grouped his managed futures account clients who have similar investment-related goals and objectives.
« Commodity trading account: the commodity trading account permits individual investors to trade and
manage their commodity futures portfolio themselves (without the services of a CTM).

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• Exchange-traded funds (ETFs): are a simple way to access the commodities market. Commodity-related ETFs
are categorized into the following major types:
« Index ETFs: attempt to passively replicate the performance of an index with a commodity-based theme.
« Commodity ETFs: are designed to provide direct exposure to the price movements of the underlying asset.
« Leveraged ETFs: are designed to magnify the returns over those of a standard, or unleveraged ETF.
• Physical commodities: Due to the bulk nature of physical commodities, very few investors invest in and take
delivery of any commodities other than precious metals.

6. Explain the merits of using real estate in a client portfolio.

• Real estate is inflation-sensitive. It will fluctuate with inflation and tends to protect the portfolio from the
effects of inflation.
• With potentially long holding periods, depending on the type and purpose of the investment, real estate
can stabilize overall portfolio returns, although it can have high volatility (real estate markets are subject to
boom-and-bust cycles).
• Overall, real estate can be considered a bond substitute with an added inflation protection feature.
7. Compare the ways to invest in real estate and mortgages.
• Real estate syndications and mortgage syndications are funds that offer opportunities to invest in specific
projects, real estate portfolios or mortgage portfolios that are not readily available to individual investors.
« Some of the more common variations of real estate syndications include the following: land banking,
brownfield development, redevelopment projects, purchasing mature properties, purchasing distressed
properties or mortgages in default, mortgage syndications, mortgage fund on a specific project, blind pools.
• Mortgage-backed securities (MBS): are another class of real estate investment.
« Two types of securities related to MBSs are: collateralized mortgage obligations and stripped MBSs.
• Real estate investment trusts (REITs): Real estate investment trusts (REITs) consolidate the capital of a large
number of investors to invest in and manage a diversified real estate portfolio. Investors participate by buying
“units” in the trust. Investors receive net returns generated by the pool, pro rata to their unit proportion.

8. Explain the benefits and risks of private equity investing.

• The benefits of private equity investing include: superior returns, absolute return goals, access to legitimate
inside information, influence over management and flexibility of implementation, and leveraging off the
statement of financial position.
• The risk of private equity investing include: illiquid investments, dependence on key personnel, down-market
performance, high management and performance fees, and blind pool investing.

9. Compare the ways in which to invest in private equity.

• Investors in private equity, whether institutional or individual, participate through three product structures:
« Direct investing: The investor enters into a financing deal directly with a counterparty. Another type of
direct investing is co-investment.
« Direct funds: Investors join a direct fund as limited partners.
« Funds of funds: A fund of funds typically invests in up to 20 funds (with each fund itself investing in 10 to
30 direct investments), thus accessing hundreds of investments for full diversification. Such diversification
means a wider spreading of investment risks.

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Products 13

CONTENT AREAS

What Are Segregated Funds?

What Are Guaranteed Minimum Withdrawal Benefit (GMWB) products?

LEARNING OBJECTIVES

1 | Explain the maturity guarantee feature of a segregated fund.

2 | Explain the role that GMWBs can play in a client’s retirement plan.

3 | Differentiate between the three GMWB guarantees.

4 | Explain how segregated funds or GMWBs bypass probate and offer creditor protection.

5 | Identify the type of client for whom a segregated fund or a GMWB would be suitable.

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INTRODUCTION
An increase in market volatility over the past decade combined with a larger percentage of the population nearing
and/or in retirement has investors increasingly looking for investment alternatives that combine an income
component, downside risk protection and upside market participation. Insurance companies have responded with
the introduction of Guaranteed Minimum Withdrawal Benefit (GMWB) products.
This chapter begins with a review of segregated funds and focuses on one aspect of segregated funds – the maturity
guarantee. An introduction to GMWB products follows. The discussion of GMWBs starts with the evolution of
GMWBs in the mid-2000s, explains how GMWB guarantees are calculated, the impact of resets and income, and
GMWB benefits and costs. GMWB underlying investments will be explained along with tax considerations. The
chapter concludes with a discussion of the types of investors who might benefit from GMWBs and the types of
accounts in which GMWBs might be held.

WHAT ARE SEGREGATED FUNDS?

Segregated funds are investment pools similar to mutual funds but with maturity and death benefit guarantees
provided to contract holders. Legally known as an individual variable insurance contract (IVIC), a segregated fund
gives the contract holder an insurance contract that pays out certain specified benefits based on the value of one
or more specified pools of assets. The life insurance company which issued the contract holds these pools of assets
separate and apart from other similar pools and its general assets. An IVIC gives a purchaser the right to choose
among various segregated pools.
Like mutual funds, segregated funds offer investors professional investment management, diversification and
the ability to invest in small amounts. Segregated funds, however, also have unique features that enable them to
meet special client needs, such as maturity guarantees, death benefit guarantees, bypassing probate and creditor
protection. This section will focus on maturity guarantees.
Unlike other types of investment funds, segregated funds are regulated by provincial insurance regulators because
they are insurance contracts. Investors who buy a segregated fund do not actually own the fund’s underlying assets.
Their rights are based solely on the provisions of the insurance contract.
Because of the insurance benefits and maturity guarantees they offer, segregated funds are more expensive than
mutual funds, which means they tend to have higher management expense ratios (MERs) than comparable mutual
funds. Before recommending a segregated fund to a client, advisors must weigh the benefits of segregated funds
against their added costs.

MATURITY GUARANTEES
One of the fundamental contractual rights associated with segregated funds is the guarantee that the beneficiary
will receive at least a partial return of the money invested. Provincial legislation requires that the guarantee be
at least 75% over a minimum 10-year holding period. Some providers of segregated funds top up the maturity
guarantees to 100%. These guarantees – whether full or partial – appeal to people who want specific assurances
about the return of the principal amount invested and a limit on their potential capital loss.
Maturity guarantees, particularly those that offer full protection after 10 years, alter the normal risk-reward
relationship associated with many investments. With a maturity guarantee, a client may participate in rising
markets without a limit on potential returns. At the same time, subject to the 10-year holding period, the client’s
invested capital (that is, the principal amount) is protected from losses.
The maturity date of a segregated fund contract is an important date. It is normally set 10 years from the contract
date and, by law, it cannot be less than 10 years. The maturity date is a critical component of the contract because
the maturity guarantee comes into effect on that date, and no sooner. So, if an investor decides to redeem a

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segregated fund contract, say, eight years from the contract date, the investor would be paid the market value of the
segregated fund holdings, whatever the market value may be on the date of redemption. The maturity guarantee
would not be triggered until the maturity date.
There are basically three types of guarantees:
1. A deposit-based guarantee will give every deposit made by the client its own guarantee amount and
maturity date.
2. A policy-based guarantee makes record-keeping simpler by grouping all deposits made within a 12-month
period and giving them the same maturity date.
3. A policy-based guarantee (the most generous type) bases all maturity guarantees on the date that the policy
was first issued. With this type of guarantee, there may be restrictions on the size of subsequent deposits to
prevent clients from making minimal deposits at account opening, and much larger deposits several years later.
Doing so would effectively shorten the holding period required for the maturity guarantee and increase the
potential risk to the insurer.

Depending on the insurance company, maturity guarantees may be based on either the entire portfolio of funds
held by a client or on each fund. A fund-by-fund guarantee is generally considered better for the client, because
holding a fund that invests in a single sector, such as a Canadian resources fund, is more risky than holding a
balanced portfolio diversified among domestic and foreign equities and fixed-income securities.
To offer greater capital protection, some insurers increase the minimum statutory 75% guarantee to 100%. The
100%-guaranteed funds feature higher management expense ratios than the 75%-guaranteed funds, reflecting the
higher risks associated with offering full maturity guarantee after 10 years. Some companies offer a series of funds
with a 100% maturity guarantee; these select funds may have to be held for a longer period of time in order to
receive the 100% maturity guarantee.
Withdrawals from a segregated fund contract may be made at any time the annuitant (the person on whose life the
insurance benefits are based) is alive. Guarantees do not apply to amounts that are withdrawn or redeemed from a
segregated fund contract prior to the maturity date. The value of the guarantees would be reduced by withdrawals,
and the insurance company must track the ongoing value of the guarantees. Typically, when deposits are made
periodically, withdrawals are made from the oldest units first. A partial withdrawal of units purchased on a particular
date reduces the guaranteed amount for the remaining units that were purchased at the same time.

AGE RESTRICTIONS
Insurance companies offering 10-year maturity guarantees that exceed the statutory requirement of 75% impose
restrictions on who qualifies for the enhanced guarantee. Normally, the restrictions are based on age. A client of a
certain age might be excluded outright from buying a company’s segregated funds. Some firms may require that the
individual on whose life the death benefits are based must be no older than 80 at the time that the policy is issued.
Alternatively, the purchaser might receive a reduced level of protection under the policy once he reaches a certain
age. Depending on the age of the client, and his requirements for death benefits, these restrictions can be a crucial
consideration in selecting a provider of segregated funds.
For the industry as a whole, provincial insurance legislation does not specify a maximum age limitation. However,
RRSP segregated fund contracts are subject to the traditional rule: termination by the end of the year in which
the contract holder (the person who purchases the contract, also known as the policy owner) turns 71. For non-
registered contracts, companies may set maximum ages for contract ownership, such as 90.

RESET DATES
Although segregated fund contracts have at least a 10-year term, they may be renewable when the term expires,
depending on the annuitant’s age. If renewed, the maturity guarantee would “reset” for another 10 years.

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Many insurers issuing segregated funds have added greater flexibility in the form of more frequent reset dates. In
some cases, holders of segregated fund contracts may lock in the accrued value before the original 10-year period
has expired and, in doing so, extend the maturity date by 10 years.
Depending on the insurance company, the reset provisions may be initiated by the policy owner or be an automatic
feature of the policy. For optional resets, there are generally limitations on the number of resets allowed each year.
Reset dates can be anywhere from daily to once a year. The daily reset feature benefits clients in rising or falling
markets. In a rising market, when the net asset value of fund units is increasing, daily resets enable contract holders
to continually lock in accumulated gains. In a falling market, when net asset values are falling, contract holders will
also be protected, because the guarantee is based on the previous high.

THE COST OF THE MATURITY GUARANTEE

In addition to the costs incurred by mutual funds, such as sales commissions, switching fees, trailer fees and
management expenses, segregated funds have added costs related to their insurance components, namely the
maturity guarantees and death benefits they offer.
The shorter the term of the maturity guarantee, the higher the risk exposure of the insurer and the higher the cost
of the guarantee. This inverse relationship is based on the premise that there is a greater chance of a decline in
the value of the fund (and hence a greater chance of collecting on the guarantee) over shorter periods. A contract
holder’s use of reset provisions also contributes to costs, since resetting the guaranteed amount at a higher level
means that the issuer will be liable for this higher amount.
The management expense ratios (MERs) for segregated funds are higher than for comparable mutual funds. With
a 75% guarantee, the cost of the insurance component becomes less onerous in comparison to a 100% guarantee.
Therefore a segregated fund with a 75% guarantee would have a lower MER in comparison to the same fund with a
100% guarantee.

TAX TREATMENT OF THE MATURITY GUARANTEE

Payments from a segregated fund contract’s maturity guarantee are taxable. The amount of tax payable depends on
whether the proceeds (net of deductible charges, for example, redemption fees) exceed the cost of the contract. The
proceeds of a contract are calculated as the market value of the segregated fund at redemption plus the value of the
guarantee received.
If more than one fund is part of the segregated fund contract, calculations are done for each fund separately.
The cost of the contract, known as the adjusted cost base (ACB), consists of the original amount deposited and any
net income or capital gains (or capital losses) allocated to the contract.
If the proceeds of the contract are less than the adjusted cost base, income tax is payable on the guaranteed
amount. However, the contract holder can use the difference between the market value of the segregated fund and
the adjusted cost base as a capital loss.
A tax specialist should be contacted to determine Canada Revenue Agency’s (CRA’s) interpretation of how the
Income Tax Act applies to each circumstance.

WHAT ARE GUARANTEED MINIMUM WITHDRAWAL BENEFIT (GMWB)

PRODUCTS?
Guaranteed Minimum Withdrawal Benefit (GMWB) products protect an investor’s retirement savings from
downside risk while at the same time providing participation in the markets and the potential for market gains.
GMWBs have maximum annual withdrawal limits (typically 5% of the initial investment) until the initial deposit
amount has been recouped over a minimum period of 20 years.

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GMWBs were introduced in Canada in late 2006 and most insurance companies developed a competing product.
GMWB product features and benefits evolved in this competitive environment. However, these product features and
benefits create additional costs for the insurer and these costs are reflected in GMWB fees charged to the investor.
GMWBs are a hybrid vehicle of investments and guaranteed income. They are segregated funds that provide an
income guarantee, a maturity guarantee and a death benefit guarantee. Traditional segregated funds have typically
been purchased by investors looking for a maturity guarantee and a death benefit guarantee. The GMWB investor
would receive a guaranteed income stream with the potential to increase the income amount with resets and
bonuses.
GMWBs are similar to an annuity in that they provide a predictable, steady stream of income for a specified
term or for the life of the annuitant. However, with an annuity, the investor gives a lump sum premium to the
insurance company in exchange for a guaranteed income that is calculated based on the premium amount, age
of the annuitant, and interest rates at the time of the purchase. With a GMWB, the investor retains control of the
investment and has the option to cash out the market value at any time, forfeit all guarantees, and terminate the
contract.
When the investor reaches the retirement stage, losses in their portfolio can be particularly serious. Earlier in
the accumulation stage, good years can balance off bad years. However, in the retirement stage, the extra return
from later good years can be lost, since part of the portfolio has to be withdrawn for income. Investor fear has
contributed to the popularity of GMWB products with the promise of guaranteed income for a specified period or
for life (under a Guaranteed Lifetime Withdrawal Benefit plan). GWMBs were designed to provide a guaranteed
income, regardless of how the markets performed, providing significant protection from market risk.

GMWBS’ GUARANTEES
GMWBs, as traditionally offered, have two phases: savings/accumulation phase and payout phase.
In the savings phase, a bonus or credit is given to the investor for each year during which no withdrawal is made.
This bonus is based on the initial deposit amount and could be 3% to 5%. So, the initial deposit could increase with
the bonuses, provided that the investor refrains from making withdrawals during the savings/accumulation phase.
The guaranteed withdrawal balance is 100% of the initial deposit amount and represents the base for which
income and bonuses are calculated. This amount does not fluctuate with the market value. Additional deposits
increase this amount dollar-for-dollar, and withdrawals within the allowable amount for the year reduce this
balance dollar-for-dollar.
Every three years, on the contract anniversary date, which is the date of the first deposit into the contract, the
guaranteed withdrawal balance is compared to the market value on that date. If the market value is greater than the
guaranteed withdrawal balance, the guaranteed withdrawal balance will be reset to the same amount as the market
value. The reset allows an increase in guarantees based on positive market performance. Income will continue until
this balance reaches zero, or beyond for contracts where income is guaranteed for the life of the annuitant(s).
The guaranteed withdrawal amount (GWA) or lifetime withdrawal amount (LWA) is the guaranteed income
amount paid for a specified period or for the life of the contract. As mentioned previously, this amount is typically
5% of the guaranteed withdrawal balance. If a withdrawal is made that is in excess of the GWA or LWA, the
guaranteed withdrawal balance will be reduced proportionately and the GWA or LWA will be recalculated based on
the new guaranteed withdrawal balance.
The death benefit guarantee is at least 75% of the initial deposit, but can be as high as 100%. The death benefit
is the minimum amount that is guaranteed to be paid to the beneficiary. The death benefit guarantee is reduced
proportionately for withdrawals.
The key benefit of GMWBs is the income guarantee as opposed to the maturity guarantee that is often one of the
objectives for purchasing segregated funds. However, because GMWBs are a type of segregated fund, they also need

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to have a maturity guarantee. The maturity guarantee on a GMWB is at least 75% of the initial deposit amount,
reduced proportionately for withdrawals.

EXAMPLE
Your new client, Donald Smith, believes in the long-run success of equity investing and has grown his RRSP
portfolio over the years by taking advantage of this belief. However, with retirement and the need to supplement
his pension income with his RRIF, he is starting to look closer at income-producing investments. He finds, to
his dismay, that currently the returns are lower than he initially expected. Donald does not want to risk his
$200,000 capital on the stock market, since he will depend on his RRIF income to maintain a comfortable
retirement lifestyle. You point out to him the benefits of GMWB plan.
A GMWB could offer several advantages for Donald. It guarantees, at a minimum, a flat income for life. He
can choose the mix of investment funds underlying his plan. The $200,000 he decides to invest will pay him a
lifetime withdrawal amount (LWA) at least of 5%, or $10,000, per year for life. However, every three years, if
the value of his underlying portfolio has increased, the guaranteed withdrawal balance will be reset to the same
amount as the market value and his LWA will be permanently reset higher, resulting in potentially higher income.
The GMWB plan provides a guaranteed income stream and the potential for capital appreciation. Donald decides
to invest in this plan because he has the certainty of the guaranteed payments and a possibility of increasing
his income. At his death, his beneficiaries will receive a death benefit guarantee amount of at least 75% of the
initial deposit (minus proportional withdrawals).

A lot has changed since the introduction of GMWBs in 2006. The 2008-09 global financial crisis resulted in a huge
decline in equity markets and investment returns dropped precipitously, starting in the US (with its subprime
mortgage crisis) but spreading to the rest of the world. The Toronto Stock Exchange’s S&P/TSX Composite Index
lost 35% of its value in 2008.
During that difficult period and in its aftermath, issuers of GMWBs were faced with multiple concerns about
solvency in the banking sector, loss of confidence of investors, plummeting returns on their investments and
demands from regulators for higher reserves to support the guarantees. So, issuers started cutting back on GMWB
offerings, increased fees and reduced features and benefits. Basically, GMWBs have become very expensive to offer
and maintain. Several providers have even discontinued offering GMWBs.

ADDITIONAL BENEFITS AND COSTS

BYPASS PROBATE
In addition to the benefits outlined, GMWBs, like segregated funds, offer an additional estate planning benefit
in that the GMWB proceeds bypass probate upon death of the annuitant, and are paid directly to the named
beneficiary. Probate fees vary from province-to-province and are calculated based on the total assets in the estate.
By reducing the total assets in the estate, the amount paid in probate fees is also reduced. GMWB beneficiaries
will typically receive the proceeds faster than proceeds that are paid into the estate as they cannot be paid to
the beneficiaries until the estate has been settled. Similar to life insurance policies, the named beneficiary of a
segregated fund contract can remain private and cannot be contested.

POTENTIAL CREDITOR PROTECTION

Because GMWBs are an insurance product, there is an additional benefit of creditor protection. However, it is
important to note that if the contract was purchased for the purpose of avoiding actions taken by creditors, it can be
challenged. Certain beneficiary designations made by the annuitant, such as spouse, parent, child, grandchild, or any
irrevocable beneficiary designation, will solidify the creditor protection.

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There are other factors that may have a negative impact on potential creditor protections such as:
• If the segregated fund contract has been assigned as collateral for a loan, the lender does have the right to seize
the assets in the case of default on the loan
• Claims against the annuitant relating to child or spousal support
• The annuitant is in arrears with Canada Revenue Agency

Creditors cannot go after money paid to beneficiaries upon death of the annuitant. However, creditors can make a
claim on any assets that make up the annuitant’s estate.

ASSURIS
Assuris provides protection to policy holders in the event that the insurance company becomes insolvent.
Membership is required for all life insurance companies in Canada who are authorized to sell insurance policies in
Canada, as dictated by the federal, provincial, and territorial regulators.
The coverage for a GMWB policy depends on whether the contract is in the savings/accumulation phase or payout
phase. According to Assuris:
• The savings/accumulation phase is defined as a contract where there has not been a withdrawal for at least 12 months.
• The payout phase is defined as a contract where a withdrawal has occurred in the past 12 months.

Coverage for a policy in the savings/accumulation phase:

• Up to $60,000 or 85% of the promised guaranteed withdrawal balance, whichever is higher.

Coverage for a policy in the payout phase:

• Up to $2,000 per month or 85% of the promised guaranteed income amount, whichever is higher.

REGULATION

Assuris provides protection to policyholders in situations where an insurance company becomes insolvent.
However, OSFI (Office of the Superintendent of Financial Institutions) is responsible for monitoring solvency
of insurance companies and dictating the Minimum Continuing Capital and Surplus Requirements (MCCSR).
These requirements ensure that the insurance companies have set aside enough reserves to cover the future
guarantees.
The Canadian Life and Health Insurance Association (CLHIA) is a voluntary non-profit association with member
companies accounting for 99% of Canada’s life and health insurance business. CLHIA also has a responsibility
to represent the best interests of the public. CLHIA’s purpose is to promote public policy, legislation and
regulation – on behalf of its members – that contribute to the betterment of the industry and economy.

COST
The additional protection against downside risk provided by GMWBs does come at a cost. The regulators require that
insurance companies have an adequate reserve to cover the guarantees. These reserves are funded by the fees charged
to the contract holders. The fees charged are typically reflective of the percentage of the guarantees. When comparing
the fees charged by the various insurance providers, all the benefits offered for the fee must also be compared.
Similar to mutual funds, segregated funds charge a MER for the funds held within the contract. The MER for
segregated funds is higher than mutual funds to cover the cost of the guarantees. The premium for a segregated
fund versus a mutual fund can be anywhere from 25 to 100 basis points (0.25% to 1.00%).
In addition to the MER, GMWBs charge an annual fee. This fee ranges from 25 to 85 basis points, depending on the
risk level of the funds held in the contract over the course of the year. The more conservative funds would charge

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a fee on the lower end of the range and growth funds charge a fee closer to the higher end. These fees are charged
by redeeming units of the funds, but this redemption is not treated as a withdrawal and does not make up part of
the 5% GWA/LWA.
The insurance component of GMWBs, that provides the benefits and guarantees, comes at an additional cost
through increased MERs and additional fees. The full cost of the MER and additional fees could be as high as 4%
or 5%. The fees are an important consideration when determining the value of the benefits and guarantees.

UNDERLYING INVESTMENTS
The assets within GMWBs are invested in segregated funds. The segregated pool of assets is separated from the
assets of the insurance provider. These segregated funds are often a fund-on-fund structure where the pool of assets
in the segregated fund purchase institutional class units of the underlying mutual fund. The daily NAV (Net Asset
Value) is calculated based on this segregated pool of assets and will be different from the mutual fund. However,
the performance will track the same as the mutual fund.
Insurance companies imposed a maximum allocation of 80% to segregated funds that invested in equities
within GMWBs. The insurer assumed risk by providing guarantees, and therefore limited the exposure to volatile
investments. Nowadays, several companies do not even offer equity funds.
Although GMWBs provide additional protection against downside risk, the portfolio of funds should be in line with
the risk tolerance of the investor.

TAXATION CONSIDERATIONS
There are a number of transactions that occur in a GMWB contract that may need to be reported for tax purposes.
For non-registered policies, these transactions include capital gains and losses resulting from fund switches
and withdrawals, fund closures, and distributions made by the fund. In addition, upon death of the annuitant
the contract is deemed to have been disposed of and any resulting capital gains or losses need to be reported
in addition to any top-up added based on the death benefit guarantee. A tax specialist should be contacted to
determine CRA’s interpretation of how the Income Tax Act applies to each circumstance.

SUITABLE INVESTORS AND ACCOUNT TYPES

GMWBs meet the needs of certain investors based on their objectives and circumstances.
In order to mitigate some of the risk the insurance company is assuming by providing the benefits and guarantees,
there is a maximum age imposed on the annuitant which applies to the initial sale of the contract and is typically
age 75 or 80.
The potential for creditor protection with segregated funds and GMWBs is an attractive benefit for business owners.
As discussed earlier, there is a cost for the insurance component of a GMWB contract. Suitable investors must feel
that there is value in the benefits and guarantees offered for the fee charged. Typically, risk averse investors may be
willing to pay a premium for the additional downside protection.
GMWBs are appropriate in registered accounts, such as RRSPs, where the intention is to withdraw no more than
the GWA/LWA or for a RRIF, a Life Income Fund (LIF) or a Locked-in Retirement Income Fund (LRIF), where the
intention would be to withdraw no more than the greater of the GWA/LWA or the minimum prescribed amount.
The minimum prescribed amount that must be paid from a RRIF/LIF/LRIF is calculated as a percentage of the market
value at the beginning of the year based on the owner’s age. This amount could be greater than the GWA/LWA
depending on market performance and the age of the owner as the minimum amount increases with age. In these
situations, the insurance company is required to pay out at least the minimum prescribed amount from the RRIF/
LIF/LRIF, even if it is in excess of the GWA/LWA. Although a withdrawal in excess of the GWA/LWA would typically
have a negative impact, there is usually no penalty for this scenario.

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SUMMARY
By the end of this chapter, you will be able to:
1. Explain the maturity guarantee feature of a segregated fund.
• Provincial legislation requires that the guarantee be at least 75% of the amount invested over a minimum
10-year holding period. Some providers of segregated funds top up the maturity guarantees to 100%.
• The maturity guarantee may be a deposited-based guarantee or a policy-based guarantee.
• The maturity guarantee may be based on either the entire portfolio of funds held by a client or on each fund.
2. Explain the role that GMWBs can play in a client’s retirement plan.
• GMWBs provide a predictable, steady stream of income for a specified term or for the life of the annuitant.
• With a GMWB, the investor retains control of the investment and has the option to cash out the market value
at any time, forfeit all guarantees, and terminate the contract.

3. Differentiate between the three GMWB guarantees.

• The guaranteed withdrawal balance is 100% of the initial deposit amount and represents the base for which
income and bonuses are calculated.
• The guaranteed withdrawal amount (GWA) or lifetime withdrawal amount (LWA) is the guaranteed income
amount paid for a specified period or for the life of the contract.
• The death benefit guarantee is at least 75% of the initial deposit, but can be as high as 100%. The death
benefit is the minimum amount that is guaranteed to be paid to the beneficiary.

4. Explain how segregated funds or GMWBs bypass probate and offer creditor protection.
• GMWBs, like segregated funds, offer an additional estate planning benefit in that the GMWB proceeds bypass
probate upon death of the annuitant, and are paid directly to the named beneficiary.
• Because GMWBs are an insurance product, there is an additional benefit of creditor protection in most cases.
5. Identify the type of client for whom a segregated fund or a GMWB would be suitable.
• The potential for creditor protection with segregated funds and GMWBs is an attractive benefit for business
owners.
• Typically, risk averse investors may be willing to pay a premium for the additional downside protection.
• GMWBs are appropriate in registered accounts, such as RRSPs, where the intention is to withdraw no more
than the GWA/LWA or for a RRIF, a Life Income Fund (LIF) or a Locked-in Retirement Income Fund (LRIF),
where the intention would be to withdraw no more than the greater of the GWA/LWA or the minimum
prescribed amount.

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 SECTION 7

INTERNATIONAL INVESTING
AND TAXATION

14 International Investing
18 International Taxation

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 International Investing 14

CONTENT AREAS

What Is the Theoretical Basis for International Investing?

What Is the Size of Global Equity Markets?

What Are the Major International Equity Benchmarks?

What Are the Primary Advantages of International Investing?

What Are the Primary Disadvantages and Risks of International Investing?

What Are Foreign Investment Vehicles?

What Are the Skills Necessary for Effective International Investing?

Do Asset Allocation Models Assess International Investment Opportunities Correctly?

LEARNING OBJECTIVES

1 | Articulate the advantages and disadvantages of international investing.

2 | Compare and contrast various investment vehicles that provide access to international markets.

3 | Incorporate international investments into an asset allocation plan.

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INTRODUCTION
International equity investing has grown substantially during the past three decades and now represents a major
portion of investors’ total equity portfolios. Since the mid-1970s, when international equity investing represented
less than 1% of individual equity allocations, the rapid growth of acceptance of foreign investments occurred
primarily for the following reasons:
1. Development and acceptance of two essential finance theories that made inclusion of foreign investments in a
well-diversified portfolio sound on a theoretical risk-return basis; with empirical evidence also supporting these
theoretical conclusions
2. Deregulation of the financial markets of the major industrialized countries
3. Development and growth of global and multinational companies and organizations
4. Explosive growth of international capital flows and the concurrent abolishment of foreign exchange controls
5. Advances in information technology

WHAT IS THE THEORETICAL BASIS FOR INTERNATIONAL INVESTING?

During the past thirty years, international investing experienced rapid growth. One of the main factors for that
growth was the extension and application of two important financial and capital market theories: the Capital
Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT). These two theories were quickly adopted by the
investment management community. They became the backbone for models and methodologies to create well-
diversified domestic investment portfolios for investors – both individual and institutional. The first applications of
these two theories were limited to U.S. domestic marketable investments for the following reasons:
1. The theories were developed and tested using historical periodic return data for only the three primary U.S.
publicly-traded asset classes (cash, stocks and bonds).
2. International investing was a very, very small market for North American investors; many large institutional
investors didn’t have exposure.

However, over the course of the 1980s, both the academic community and the investment industry started to
test and apply the two theories. They did so in a manner that included international investments as part of the
investable universe for the application of these theories. This provided the theoretical rationale for international
investing. The allocation to international investments started in earnest following the leadership of a number of
large institutional investors. It then spread into the financial advisory community that services individual investors
and small institutional investors.
These two theories, along with suitable historic rate of return data, permitted investors to structure a well-
diversified investment portfolio that offered a better risk-return trade-off than investing with purely domestic
equities alone.
These two models are still widely accepted and applied. However, the level of concern has been increasing recently
with the correlation of international markets, both within themselves and with the North American capital markets,
starting to increase. The specific concern is that the world’s capital markets appear to be exhibiting high and
increasing correlation.
Currently, significant analysis is being conducted in this area. The analysis aims to determine if the limitations of
the assumptions supporting these two theories are, or have been, affected by the significant bouts of capital market
turbulence that has occurred in the past fifteen years. In fact, correlations might not tell the entire story.
Some of these studies might conclude that diversification benefits from international investing still exist. The
importance of industry factors might rival the impacts of country factors, when constructing well-diversified

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investment portfolios. Company factors may also be determined as the most important factor. This is where the
markets for its products are located, rather than the country of domicile for the company’s global headquarters, or
main stock market listing.

WHAT IS THE SIZE OF GLOBAL EQUITY MARKETS?

At year-end 2016, the global equity markets’ total market capitalization was approximately US$ 71 trillion
(Source: World Federation of Exchanges). Canadian equity market capitalization contributed approximately 3%
of this total. Table 14.1 shows the market capitalization and global market share information for each of the three
major constituent geographical regions: Americas (which include Canada), Asia Pacific, and Europe-Middle East–
Africa (EMEA) respectively.

Table 14.1 | Global Equity Markets 2016

(US$ Trillions and Percentage of Global Total)

Geographic Region Market Capitalization (US$ trillion) Global Market Share
Asia Pacific 24.4 34.4%
EMEA 15.6 22.0%
Americas 30.9 43.6%
Source: World Federation of Exchanges

Table 14.2 shows the change in the share of total equity market capitalization for each of the three geographic
regions for the years 2000 and 2016. The Americas is the largest area by market capitalization, but by a smaller
margin in 2016, as the fast growing Asia Pacific region continues to catch up. The Asia Pacific region has experienced
tremendous market value growth, particularly in the Chinese markets.

Table 14.2 | Global Equity Markets, 2016 vs. 2000

2000 2016 Change

% of Total Global % of Total Global % of Total Global
Americas 53.2 43.6 -9.6
EMEA 31.0 22.0 -9.0
Asia Pacific 15.8 34.4 18.6

The shift of global equity capitalization weighting has been quite profound, and has occurred over a relatively short
period of time. Investors in international markets must remain cognizant of these shifts and must modify their
international investment strategy accordingly.

WHAT ARE THE MAJOR INTERNATIONAL EQUITY BENCHMARKS?

The availability and use of appropriate passive benchmarks is an integral part of successful investing, regardless
of asset class, market sector or sub-sector, and most importantly for this chapter, domestic and international
investing.

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To be useful and adopted by academics and practitioners alike, a passive benchmark must have a number of
attributes:
• The benchmark can be constructed in advance of analysis.
• There is a well-defined methodology regarding individual security inclusion/exclusion rules and weighting.
• It is entirely transparent (regarding constituent composition and weighting methodology).
• Data is publicly available on a timely basis.
• The benchmark is frequently valued (daily is the standard).
• The benchmark has a long valuation history (preferable).
• There are very few and infrequent changes in construction methodology.
• The benchmark has investable constituents.

There are a number of equity market benchmark indices (and sub-indices) available for international investing.
The most popular international equity market indices are from the following organizations:
• MSCI Inc.
• S&P Dow Jones Indices

MSCI EAFE
MSCI’s Europe, Australasia and Far East (EAFE) equity market index is the most popular international equity
market index by a substantial margin. It is designed to represent the performance of the equity markets in
developed markets, excluding the United States and Canada.
The index is based on a selection of suitable stocks (i.e., market capitalization, trading volume) from 21 countries,
excluding the United States and Canada.
EAFE is a free-float market-capitalization index. This means that the weight of each company included in the
index is based on the current number of shares readily available in the market, rather than the number of shares
outstanding, some of which might be in restricted hands. When constructing the index, MSCI first ranks the
investable equities from largest market capitalization to smallest. This market capitalization list is then used to
populate their international equity market indices as follows:
• MSCI EAFE Large Cap Index: The top 70% of market capitalization
• MSCI EAFE Standard: The top 85% of market capitalization
• MSCI Investable Market Index (IMI): The top 99% of market capitalization

S&P DOW JONES INDICES

S&P Dow Jones Indices publishes indices that pertain to global equity markets. The S&P Global Broad Market Index
(BMI) includes approximately 10,000 stocks from 25 developed markets and 23 emerging markets. The S&P Global
BMI is a float-adjusted, market capitalization weighted index.
The S&P Global 1200 Index contains 1,200 stocks that comprise approximately 70% of the world’s capital markets.
The index has over a 50% weighting in U.S.-based companies, which limits its ability to represent an international
index for North American investors.
The S&P 1200 Global Index has some popularity with managers of global equity index products. It is often used as
the basis for a number of structured investment products that provide global equity exposure.

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WHAT ARE THE PRIMARY ADVANTAGES OF INTERNATIONAL

INVESTING?
There are three primary advantages of investing internationally.

DIVERSIFICATION
One of the major advantages offered by international investing is to diversify the source, magnitude and timing
of returns for the investor’s overall portfolio. Foreign equity markets primarily respond to the unique political,
economic and financial factors associated with the countries that the foreign company operates in. These factors
result in share price movements that can be quite different in size and timing, versus movements in the investor’s
domestic equity markets, in all but the most extreme situations.

EXPOSURE TO EMERGING MARKETS

Emerging markets are those non-developed countries with high rates of economic growth. These countries might be
in the process of becoming increasingly industrialized or may still be significantly agricultural-based. There are local
capital markets, some financial infrastructure and regulations but emerging markets do not have the same level of
market efficiency or regulation as developed economies.
The domestic investor’s interest in the equity markets of emerging countries is attributed to interest associated with
the capital market performance of the Four Asian Tigers (Hong Kong, South Korea, Singapore and Taiwan) in the
1970s and 1980s. Currently, the geographic scope of emerging markets has widened to include a number of former
Soviet Union countries, China, Mexico, some South American countries and several additional Asian countries.

EXPOSURE TO UNIQUE COMPANIES

There are a number of industries and companies in foreign markets that have world-class operations and dominate
or compete very effectively against their North American-based competitors. International investing allows the
domestic investor the ability to gain exposure to these particular companies. Current examples include exposure
to Japanese, South Korean and Taiwan computer chip manufacturers. Various manufacturers located in these three
countries dominate the global market for computer chips and represent the lion’s share of the most advanced chip
manufacturing capacity in the world. North American investors trading domestically would limit themselves to Intel
and Advanced Micro Devices.
Let’s now turn our attention to some of the primary disadvantages of international investing.

WHAT ARE THE PRIMARY DISADVANTAGES AND RISKS OF

INTERNATIONAL INVESTING?

EXPENSES
Investment in international equities normally involves higher expenses than comparable investment in domestic
equities. Almost all types of investment related fees, ranging from broker commissions and stock exchange fees
through to custodial and administrator fees, are generally higher than those associated with domestic equity
investments, occasionally by a significant margin.
These higher transaction related fees, coupled with higher investment manager fees for international investment
services, generally result in international equity and global equity mutual funds having the highest management
fees of any type of mutual fund.

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LIQUIDITY RISK
In general, from the individual investor’s perspective, liquidity is not a problem in the majority of mid-cap and large-
cap issuers in most on the international equity markets. However, liquidity does start to drop off dramatically for
small cap names in many international markets.
Concurrent with less liquidity, the bid-ask spreads tend to be larger for small cap international issuers as compared
to their domestic counterpart. This essentially translates into higher costs (for both buying and selling) in these
markets.

LEGAL AND ACCOUNTING BASES

Shareholder (and bond investor) legal rights can vary by country, sometimes substantially. Corporate governance
standards are anything but uniform in international markets, and especially in a number of the emerging economies
markets. Some countries, such as China, have multi-tiered equity markets, where shares of the same company are
issued with different associated shareholders rights and privileges, and even trade on different exchanges.
As of 2017, U.S.-listed companies prepare their financial statements in accordance with U.S. Generally Accepted
Accounting Principles (GAAP). Companies listed on most exchanges outside of the U.S. do not use U.S. GAAP, but
instead prepare their financial statements in accordance with International Financial Reporting Standards (IFRS).
The two accounting standards are largely the same. However, on occasion, there can be differences that investors,
or their advisors, need to be cognizant of for certain companies.
The investor must also rely on foreign legal remedies in case shareholder (or lender) litigation occurs. Even if the
domestic investor is successful in suing the foreign company in the investor’s domestic courts, it may prove very
difficult to collect a judgment against the foreign company. Investors have to rely on whatever legal remedies are
available in the company’s home country.

SHAREHOLDER COMMUNICATIONS
Shareholder communications, in terms of reliability, quality, level of detail, and frequency of reporting, can also vary
drastically for international equities compared to North American issuers, as well as between various international
markets themselves. Domestic investors can become frustrated by the difficulty and effort sometimes required to
obtain timely information about companies, particularly those of some emerging markets.

FOREIGN EXCHANGE RISK

Almost all international investment involves foreign exchange risk. This risk can be present on more than one level.
The first, and most direct, foreign exchange-related risk is that the market price of the foreign equity is not priced
in the investor’s currency. If the value of the foreign currency in which the share price is denominated falls in value
relative to the investor’s home currency during the securities holding period, the value of the investor’s foreign
holdings will decrease immediately.
Secondly, the foreign company might sell a large portion of its products in its export market and not hedge these
foreign currency revenues to its own base or reporting currency. This introduces a type of “hidden” currency risk for
the international investor. The foreign company’s financial performance can be negatively impacted if its revenues
are not hedged to its reporting currency. In this case, the company’s share price can be negatively affected if the
(un-hedged) revenues are in depreciating currencies and, when converted into the reporting currency, reduce the
revenues and profits of the foreign company.

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SOVEREIGN RISK
It can be quite difficult for investors to understand all of the political, economic and social factors that influence
foreign capital markets. This risk generally increases, and can become significant, as the investor moves his focus
towards emerging markets. Some of these countries do not have a long history of operating in relatively stable
domestic economies or financial markets.
Sovereign risk also arises by virtue of the product markets the foreign company is selling to. The foreign company, in
itself, is exposed to sovereign risk, which in turn affects the company and its share value. An example of this would
be a Canadian investor holding an investment in a mining company listed on the Johannesburg Stock Exchange
that has just had one of its larger operating mines, located outside of South Africa, expropriated by the foreign
government.

WHAT ARE FOREIGN INVESTMENT VEHICLES?

There are three primary ways for investors to invest internationally.

DIRECT INVESTMENT
In general, this type of foreign investment is the most risky method of obtaining exposure to international
investment. Direct investment can occur in two primary ways.
First, the investor can invest in a foreign company on a direct basis as a private placement or investment in an
unlisted security. This option is not normally within the realm of the typical Canadian investor and should only
be undertaken by those individuals with extensive knowledge and experience of the company and the country’s
sovereign risks.
The second and more popular form is through the purchase of the publicly-traded shares of individual foreign
companies. This is generally considered the second most risky method of international investment. This type of
investment not only requires the full set of investor skills for successful international investing, but also carries the
additional (and often significant) risk that the investor’s international investment portfolio will not be sufficiently
diversified.
Direct investment in international equities is usually accomplished by purchasing the equities of the foreign
company directly on the foreign company’s domestic stock exchange. This involves a number of brokerage, custodial
and administration challenges, and additional expenses for Canadian investors.
As mentioned previously in chapter 4, alternatively, American Depositary Shares (ADSs) are a more efficient method
of direct international equity investment. Buying ADSs is the equivalent of buying the company’s common stock,
but on the investor’s domestic exchange. ADSs are exchange-listed shares of a trust, or special purpose company
(SPC), whose sole purpose is to hold a certain number of common shares of the issuer’s common stock. These
pledged shares form the collateral for the ADS trust, and are placed on deposit with a custodian bank or other
reliable financial intermediary in the home country of the underlying company. ADSs are issued only for the most
liquid and well known international companies. ADSs are only listed on U.S. stock exchanges.
Although ADSs have been available for decades, it should be noted that ADSs still represent a somewhat “novel”
method for a foreign company to access international investors. However, with the ongoing globalization of the
world’s major capital markets, large international companies are electing instead to list their common stock directly
on a select number of foreign stock exchanges in order to make their shares more accessible to foreign investors. As
such, the ADS market has not seen major growth in terms of the number of new ADSs issued.

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MUTUAL FUNDS
Domestically distributed mutual funds with international investment mandates have historically been the most
popular and recommended method of obtaining international investment exposure. Most mutual fund companies
offer some form of a foreign equity fund, and often in more than one mandate. Until the advent of exchange-
traded funds (ETFs), most international investment exposure for Canadian individual investors was through
investment in suitable mutual funds.
International investment through mutual funds provides the advantages of diversification, dedicated professional
investment management expertise, liquidity and so forth. Funds are offered on both a passive and active investment
management style. Passive style mutual funds are designed to track international or global equity benchmarks.
Some active international mutual funds are run by managers with considerable experience in international equity
markets.

EXCHANGE-TRADED FUNDS (ETFs)

ETFs have quickly and firmly established their place in the field of investment options available to investors – both
individual and institutional. Although the ETF industry is relatively new, international mandates were added to their
offerings early. This was probably done as a result of the vast investor interest in international investing via mutual
funds.
The growing popularity of both international investing and investing in ETFs has resulted in an explosion in the
number and types of ETFs with international investment objectives available to Canadian investors. Virtually all
ETFs offered have passive investment management styles tracking the performance of popular international equity
market indices provided by third parties. Some ETFs, however, are designed to track a performance benchmark that
is custom designed by the ETF’s investment manager.
Below are brief descriptions and examples of the primary types and categories of ETFs with international or global
investment mandates.

BROAD-BASED INTERNATIONAL ETFS

These types of ETFs have the broadest investment mandates of all international ETFs. They are generally designed
to passively track widely used international equity indices, such as the EAFE. They are viewed as the best method
(at least in the ETF world) for obtaining exposure to international investment on a well-diversified basis. Not
surprisingly, these are by far the most popular international ETFs.

REGIONAL ETFS
These types of ETFs provide exposure to a specific region or group of international equity markets. These are regions
with developed economies, emerging economies or both. One popular regional ETF theme covers the BRIC group
(Brazil, Russia, India and China). An example of a regional ETF is the Guggenheim BRIC ETF (ticker symbol: EEB).
Other popular regional ETFs provide exposure to regions of the world, such as Asian-based ETFs, Europe-based ETFs
and even Latin America-based ETFs.

INDIVIDUAL COUNTRY ETFS

These ETFs provide diversified exposure to the equity markets of an individual country. Passive investment
mandates attempt to match the performance of either the popular equity market indexes available for the country
or a custom-made benchmark for the country. Note that these country-based benchmarks, whether popular indices
or custom made by the ETF manager, tend to have minimum capitalization cutoffs and tend to include only larger
capitalization companies.

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An example of a specific country ETF is the iShares MSCI Germany ETF (symbol: EWG). This ETF tracks the
performance of the MSCI Germany Index. This is a diversified index designed to be representative of the German
economy.

FOREIGN STYLE ETFS

ETFs considered “foreign style” cater to investors who want international equity exposure, but want that exposure
to be gained by use of specific investment styles. Such investment style parameters include the popular size style
criterion, small-cap, mid-cap or large-cap, and valuation styles, growth, value, growth at a reasonable price (GARP)
or a combination of these.
An example of a style-based ETF is the iShares MSCI EAFE Small Cap ETF (symbol: SCZ). As its name implies, it is
designed to track the performance of the small-cap component of the MSCI EAFE Index.

INTERNATIONAL BOND ETFS

Although the focus of this chapter has been on obtaining international investment exposure via international
equity markets, there is increasing interest in adding international bond exposure to well-diversified domestic and
international portfolios. This type of ETF allows investors to add a fixed income component to their portfolio, and
receive the benefits and rewards associated with a fixed income type of investment. These particular ETFs offer the
ability to increase the exposure to international markets, as well as earn a revenue stream.
One popular foreign bond fund-type of ETFs is the SPDR Bloomberg Barclays International Treasury Bond ETF
(symbol: BWX).

FOREIGN DIVIDEND ETFS

Foreign dividend ETFs are essentially a “philosophical” combination of international equity style ETF investing and
(to a lesser degree) international bond ETF investing. These types of ETFs invest primarily in equities that offer an
income stream (dividends), and appeal to investors who want to diversity the potential return of their international
portfolio away from capital gains and coupon income.
An example of a foreign dividend ETF is the WisdomTree Asia Pacific ex-Japan Fund (symbol: AXJL).

FOREIGN CURRENCY ETFS

Another way to bet on the future performance of an economy is through investment in its domestic currency by
using ETFs. The theoretical argument of these investors is that a country’s currency is a more accurate measure of
the economy than the returns in the same country’s equity markets.
An example of a foreign currency ETF is the Guggenheim CurrencyShares Australian Dollar Trust (symbol: FXA). This
particular fund invests in the Australian dollar.

COMMODITY THEMED ETFS

Generally, commodity themed ETFs invest directly or indirectly in commodities themselves or in the companies that
produce commodities. Some investors regard commodity investment as an integral part of their total investment
portfolio. It is viewed as a bet on the direction of the global and/or regional economies. It is also seen as an effective
diversifier for solely domestic investment portfolios. As such, it is viewed as a constituent part of the international
investment component of the investor’s portfolio. An example of a commodity themed ETF is the iShares S&P/TSX
Global Gold Index ETF (symbol: XGD).

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WHAT ARE THE SKILLS NECESSARY FOR EFFECTIVE INTERNATIONAL

INVESTING?
International investing requires many of the same investment skills required to successfully manage domestic
investment portfolios. However, the various disadvantages and risks associated with international investing require
a different set of skills for success in international investing.
Below are the key required skills and brief descriptions.

KNOWLEDGE OF ASSET ALLOCATION TOOLS

The investment advisor should have an in-depth understanding of the theory that the asset allocation model is
based on, as well as the limitations pertaining to the application of its outputs. Accordingly, the investment advisor
should appreciate the sensitivity of the model’s recommended optimal asset mixes to various pre-defined changes
in the model’s input values and assumptions. This is generally accomplished by performing sensitivity analysis based
on different sets or combinations of input assumptions. This will determine how sensitive the model’s solutions are
to changes in these various input variables.
When considering investment in emerging markets in particular, it is important to realize that there are often
limitations on the amount (and quality) of available historic return series data for foreign market indices or other
parameters. In some instances, using this less than robust data could lead to situations where the resultant asset
mix allocations are actually not statistically valid, and therefore useless.

SENSITIVITY TO ADDITIONAL COSTS AND EXPENSES

The investment advisor should also be sensitive to the various costs and expense associated with trading in
international capital markets. Brokerage commissions and other associated trading-related fees vary by market.
In some cases, the fees can be multiples of the amount incurred for a similar size and type of transaction in
the domestic markets. These extra costs can materially affect the client’s returns, especially in cases where the
international investments are managed actively.

FAMILIARITY WITH FOREIGN TRADING AND SETTLEMENT CONVENTIONS

Each international capital market has its own unique trading and settlement conventions. Failure to clearly
understand these differences can negatively impact the client’s returns. Trade orders may not be processed in a
timely manner or fail. These can also be a huge source of embarrassment for the investment advisor.

SENSITIVITY TO THE DIFFERENT VOLATILITY LEVELS OF INTERNATIONAL

CAPITAL MARKETS
There is a popular adage that states, “If the U.S. capital markets sneeze, international capital markets catch a cold! ”
Investment advisors need to be familiar with the increase in volatility that occurs in various international markets,
especially in times of unstable North American capital markets. How this increased volatility is symptomatic of
increased correlation among the various global capital markets is important to understand.
Asset allocation models use long-term rates of return. These time series data sets do not typically exhibit the degree
of increased positive correlation in North American markets today. The problem tends to become most acute when
the U.S. capital markets are volatile and falling.
This recent phenomenon is creating situations where, in times of heightened U.S. market volatility, a client’s
diversified portfolio that includes an international equity allocation actually declines in value more than the U.S. or
Canadian stock market. This occurs because the foreign equity markets become more positively correlated. Due to
their higher beta, they often fall even more in value than the U.S. and/or Canadian equity markets.

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In these instances, most clients feel that diversification into international markets hurts, more than helps. Higher
correlation among the world’s equity markets, during periods of both low and heightened volatility, might be one of
the negative consequences of the ongoing capital market and economic globalization process.

DO ASSET ALLOCATION MODELS ASSESS INTERNATIONAL

INVESTMENT OPPORTUNITIES CORRECTLY?
The phenomenon of increased positive correlation between international markets since the turn of the millennium
has cast some doubt on the usefulness of mean variance optimization (MVO) models going forward. One possible
explanation of the phenomenon is that MVO theory is correct, but the way the data inputs are considered might
not result in the correct or optimal solutions.
One aspect that requires investigation is that asset allocation modeling is done at the “country level” (referred to
as country factors) and by asset class in each respective country under consideration (i.e., U.S. equities, U.S. bonds
and U.S. cash). While it may be easy to conceptualize, explain, and use (due to the availability of return data sets
for each asset class), it is not necessarily clear or evident that this is the best way to analyze the asset allocation
problem.
Due to the ongoing integration of both the major capital markets and economies, it might be more appropriate to
perform asset allocation analysis on the basis of industry factors, with little or no consideration to the trading or
operating domicile of the constituent companies. Arguably, in an increasing globally integrated economy, global
factors affect companies in similar industries by a more significant amount than the level of economic activity and/
or the strength of the stock market in the country where a company’s stock is listed. For example, the global price
of crude oil likely affects the market value of BP p.l.c. (London Stock Exchange-listed) and ExxonMobil Corporation
common stock (NYSE-listed) more than the overall stock market movement in their respective exchanges.
This argument and analysis can be taken one step further to consider asset allocation on a company factor level.
BP and ExxonMobil, for instance, each obtain more than half of their respective total revenues from and make more
than half of their respective capital investment into nations outside of their headquarter countries of England and
the U.S.

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 CHAPTER 14 | INTERNATIONAL INVESTING 14 • 13

SUMMARY
By the end of this chapter, you will be able to:
1. Articulate the advantages and disadvantages of international investing.
• Advantages:
« Diversification: diversify the source, magnitude and timing of returns for the investor’s overall portfolio.
« Exposure to emerging markets: emerging markets are those non-developed countries with high rates of
economic growth.
« Exposure to unique companies: There are a number of industries and companies in foreign markets that
have world-class operations and dominate or compete very effectively against their North American-based
competitors.
• Disadvantages:
« Expenses: almost all types of investment related fees, ranging from broker commissions and stock exchange
fees through to custodial and administrator fees, are generally higher than those associated with domestic
equity investments.
« Liquidity risk: liquidity does start to drop off dramatically for small cap names in many international
markets.
« Legal and accounting bases: shareholder (and bond investor) legal rights can vary by country, sometimes
substantially.
« Shareholder communications: in terms of reliability, quality, level of detail, and frequency of reporting, can
vary drastically for international equities compared to North American issuers.
« Foreign exchange risk: the first, and most direct, foreign exchange-related risk is that the market price of
the foreign equity is not priced in the investor’s currency. Secondly, the foreign company might sell a large
portion of its products in its export market and not hedge these foreign currency revenues to its own base
or reporting currency.
« Sovereign risk: it can be quite difficult for investors to understand all of the political, economic and social
factors that influence foreign capital markets.

2. Compare and contrast various investment vehicles that provide access to international markets.
• There are three primary ways for investors to invest internationally:
« Direct investment:
• the investor can invest in a foreign company on a direct basis as a private placement or investment in an
unlisted security.
• The investor could purchase the publicly-traded shares of individual foreign companies.
• The investor could purchase American Depositary Shares (ADSs). Buying ADSs is the equivalent of buying
the international company’s common stock, but on U.S. stock exchanges.
« Mutual funds: international investment through mutual funds provides the advantages of diversification,
dedicated professional investment management expertise, and liquidity.
« Exchange-traded funds: Virtually all ETFs offered have passive investment management styles tracking the
performance of popular international equity market indices provided by third parties.

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3. Incorporate international investments into an asset allocation plan.

• It might be more appropriate to perform asset allocation analysis on the basis of industry factors, with little or
no consideration to the trading or operating domicile of the constituent companies.
• Analysis can be taken one step further to consider asset allocation on a company factor level.

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 SECTION 8

MANAGING YOUR CLIENT’S

INVESTMENT RISK

15 Managing Your Client’s Investment Risk

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 Managing Your Client’s
Investment Risk 15

CONTENT AREAS

What Are Investment Risks?

How Is Investment Risk Measured?

How Can Diversification Reduce Investment Risk?

How Can Using Options Reduce Investment Risk?

How Can Using Futures Contracts Reduce Risk?

How Can Using Contracts For Difference (CFDs) Reduce Risk?

How Can Using Principal-Protected Notes (PPNs) Reduce Risk?

LEARNING OBJECTIVES

1 | Explain how various risks can affect investment portfolios.

2 | Evaluate portfolio investment risk.

3 | Recommend and justify a diversification strategy that reduces investment portfolio risk.

4 | Explain how option strategies can reduce investment portfolio risk.

5 | Explain how futures and contracts for difference (CFDs) can reduce investment portfolio risk.

6 | Recommend investments with built-in risk reduction features in appropriate circumstances.

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INTRODUCTION
To help clients achieve the return which will enable them to meet their personal and financial goals, advisors have
to know what risks to accept, how much risk to carry and how much is fair compensation for accepting that risk.
This chapter will review the four basic risks faced by most investors: how to measure overall risk of a security or
portfolio, how to quantify the risk, how to calculate the fair amount of return for that risk and finally how to tailor
an acceptable amount of risk into client portfolios.

WHAT ARE INVESTMENT RISKS?

Although there is no universally agreed-upon definition of investment risk, one interpretation that has gained
widespread acceptance is the volatility of returns, which is defined as the extent to which returns on a security
or portfolio differ from some average or expected level of return. The more volatile returns are, or the more an
individual return differs from the average or expected return, the greater the risk.
A security or portfolio’s volatility is often referred to as the total risk of the security. In 1964, William Sharpe
published a paper of seminal importance titled “Capital Asset Prices – A Theory of Market Equilibrium under
Conditions of Risk.” In his paper, Sharpe developed a model that, under a certain set of assumptions, could be used
to determine the expected return on any asset. One of the most important features of the model, which became
known as the capital asset pricing model (CAPM), was the separation of total risk into market or systematic risk
and non-market, specific or unsystematic risk.

Systematic risk, or Refers to the portion of a security or portfolio’s total risk that is related to fluctuations
market risk in the return on the overall market. For example, when the market goes up, the prices
of most securities go up, and when the market goes down, the prices of most securities
go down. The degree to which the value of a security or portfolio of securities goes up
or down relative to these moves in the overall market is a measure of its systematic risk.
For equity securities, the “overall market” is usually represented by a broad-based stock
market index, such as the S&P/TSX Composite Index for Canadian equities, or the S&P
500 Index for U.S. equities. For debt securities, market risk is better known as interest
rate risk, and the “overall market” is usually represented by the interest rates on federal
government bonds.

Unsystematic risk Refers to the portion of a security or portfolio’s total risk that is not related to
fluctuations in the overall market. Unsystematic risk is unique to each security or
portfolio. For example, on a day when the overall market goes up because of unexpected
economic news, a company may report disappointing earnings that cause its stock price
to fall. Similarly, an equity portfolio with a significant allocation to automobile and
automobile parts stocks may suffer because of weak auto sales.

One of the most significant conclusions of the capital asset pricing model is that the expected return of a security or
portfolio is directly related to the security’s or portfolio’s systematic risk. Therefore, systematic risk is an important
consideration for all investors. The measure of systematic risk described by Sharpe is known as beta.
While total risk can be partitioned into systematic and unsystematic risk, this breakdown does not adequately
describe the actual source of the risk. For example, while it is clear that significant declines in the overall equity
market will mean that most securities will also decline, it may not be clear what is causing the decline in the overall
market. To determine the cause, it is necessary to look deeper at the source of risks to investment portfolios. While

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there is an almost endless list of risk sources, the following four are some of the most common risks faced by
investors and clients today:
1. Inflation or purchasing power risk
2. Credit risk
3. Liquidity risk
4. Currency risk

INFLATION OR PURCHASING POWER RISK

Inflation risk arises because of changes in the purchasing power of a currency over time. Inflation is a serious
concern for clients, who over time will need to generate a return equal to at least the rate of inflation to ensure that
their purchasing power remains intact.
Compounding the problem is the fact that inflation is bad for most investments. Stocks do poorly in inflationary
environments, as the spiral of rising costs and the threat of higher interest rates cause investors to sell their stocks in
search of safer havens. A diversified equity portfolio is one of the best defences against inflation risk since, although
it may experience a short-term impact, over the long term, equities outperform not only other asset classes but the
long-term inflation rate as well.
Inflation risk is also a significant risk for investors in debt securities with fixed coupon rates. Although the actual
nominal dollar amount of interest and principal payments is known in advance, if the rate of interest is ultimately
less than the rate of inflation, the purchasing power of the investment declines. Given the significance of inflation
risk for bond investors, some issuers, primarily governments (including the Government of Canada and the U.S.
Treasury), have issued real return bonds, which guarantee a real rate of return over and above the rate of inflation.

CREDIT RISK
Credit risk is the risk of loss from deterioration in the credit quality of corporate issuers and securities. Credit risk is
often associated with corporate debt securities, but it can be a significant factor in the performance of a company’s
equity securities as well. Credit risk can also be a serious concern for those investing in bonds issued by governments
facing significant economic challenges.
The owners of debt securities are primarily concerned with the issuer’s ability to make timely payments of interest
and principal. The issuer is said to be in default if timely payment is not made. The risk that an issuer may default on
interest and/or principal payments is often referred to as default risk.
Although the owner of a debt security has certain rights as a creditor of the issuer, the debt security does not convey
ownership rights. Rather, creditors have a claim on the borrower’s income (and, in the case of bankruptcy, assets)
based on their claim’s place in the ranking of corporate liabilities. Although the ranking of the debt security and the
trust indenture represent important legal obligations of the issuer, they do not measure the ability of borrowers/
issuers to meet their obligations in a timely manner. Evaluating an issuer’s ability to meet timely payments is known
as credit analysis, and is performed by credit rating agencies that communicate the results of their analysis in the
form of a credit rating. Some investment dealers and institutional investors also employ their own team of credit
analysts.
Any decision by an issuer to default on its debt securities will have an adverse impact on the company’s equity
securities. Any company that is unwilling or unable to make interest payments on its debt securities is basically
saying that it is in bad financial shape. Given the low priority that equity investors have compared to debt investors
in the ranking, this will almost always result in a decline in the value of the company’s equity securities, especially
common shares.

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LIQUIDITY RISK
Liquidity risk concerns the ease with which an investment can be sold at or near a price equal to its true value. The
bid-ask spread, the amount by which the asking price exceeds the bid price, is usually interpreted as an indicator of
the liquidity risk for an investment. The wider the bid-ask spread, the greater the liquidity risk.
Liquidity risk is often associated with small capitalization stocks, whose trading volumes and general interest among
analysts and investors is small compared to that of larger cap stocks. In Canada, however, many mid-cap and
even large cap stocks have significant liquidity risk. The Canadian equity market is simply not that large compared
to many other equity markets, and significant trading volumes and small bid-ask spreads on any given day are
restricted to a small number of stocks.
Clients will also be exposed to liquidity risk in other types of securities. The retail bond market has always been one
with a lack of transparency, which has translated into wide bid-ask spreads for clients.

CURRENCY RISK
Most clients’ investment portfolios will be exposed to currency risk, which is the risk of loss from adverse
movements in the value of a foreign currency in terms of the Canadian dollar. (If the client is a resident of a country
other than Canada then the client’s currency risk is relative to his or her home currency.) Most of this currency risk
is incurred by investing in securities that are valued in terms of a foreign currency (most commonly, the U.S. dollar).
If the value of the foreign currency declines relative to the Canadian dollar, the security’s value in terms of Canadian
dollars will fall, even if the value of the security in its base currency did not change.
Owning foreign currency denominated securities results in exposure to currency risk. Clients can be indirectly
exposed to currency risk if they have invested heavily in the common shares of companies valued in Canadian
dollars but doing significant volumes of their business in a foreign currency. For example, a Canadian company
might earn all or most of its revenue in a foreign currency while paying most or all of its expenses in Canadian
dollars. Or it might earn revenue in Canadian dollars but pay expenses in a foreign currency. The company might
face significant losses if the value of the foreign currency moved adversely, and the Canadian dollar value of the
security would likely decline as a result.
For most of the 20th century, currency risk was of little concern to most investors because they primarily invested
in securities in their home countries and the level of international trade was a small fraction of global economic
activity. But things have changed. Influential academic and practitioner-oriented research has highlighted the
benefits of diversifying into foreign securities, and international trade has grown significantly as companies have
tapped foreign markets for sources of growth. Financial markets around the world have also become highly
integrated as advances in computing and telecommunications technology make it easy for investors in one country
to access markets in other countries.

HOW IS INVESTMENT RISK MEASURED?

Several investment risks have been identified and described earlier including total risk (which is comprised of
systematic and unsystematic risk), inflation risk, credit risk, liquidity risk and currency risk. The most commonly
quoted measures of risk are those that measure the total risk of an investment or the systematic risk of an
investment.
For wealth managers, measuring the inflation risk, credit risk, liquidity risk and currency risk of a client’s portfolio
will be more of a qualitative exercise than a quantitative one. For example, inflation risk, which is the risk of a
portfolio underperforming the rate of inflation, can be measured precisely only with perfect knowledge of both
the future return on a client’s investments and the future rate of inflation. At best, both of these will be educated
estimates. Similarly, the credit risk of a client’s investments can be measured by the credit ratings assigned to the

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investments in the portfolio, which, again, are educated estimates provided by a credit ratings agency. There is no
precise formula that these credit ratings agencies use to determine the credit risk of an investment.
While it is important that the advisor understand how all of these can potentially impact client investments, from
a quantitative perspective it is more useful to focus on a few overall risk measures frequently used in managing and
protecting investments, particularly the standard deviation of returns and beta.

MEASURES OF HISTORICAL AND EXPECTED RISK

Before investigating these measures of risk, it is important to distinguish between measures of historical risk and
measures of expected risk. It is important to determine whether a measure of investment risk is referring to a
measure of the past, or historical, risk of the investment, or to a measure of the future, or expected, risk of the
investment. As the term suggests, historical risk (or realized risk) measures describe the actual risk experienced by
an investment in a past time period. An investment’s expected risk, on the other hand, is an individual’s or firm’s
estimate of what the investment’s risk will be over some future time period. The estimate may, in fact, be a guess
based on some fundamental analysis of the investment, or it may be a probabilistic determination based on various
scenarios for the investment and the market or economy, or anything else that is deemed to drive the risk of the
investment. It may even be based on an investment’s past realized risk.
Realized risk is the risk exhibited by the investment over some historical time period. The realized risk, however it is
measured, represents past risk. Just as past returns are never a guarantee of future returns, historical risk should not
be considered a perfect indicator of expected risk. That being said, investment risks do tend to be more consistent
over time than investment returns.

POPULAR MEASURES OF INVESTMENT RISK

While there is no universal agreement of an acceptable measure of investment risk, a few measures have gained
widespread acceptance within the investment industry. One of these, the standard deviation of returns, measures
the total risk of an investment; while the other, beta, measures the systematic risk of an investment relative to the
return on a benchmark index.

STANDARD DEVIATION OF RETURNS

The standard deviation of returns, or just standard deviation, measures the extent to which investment returns
differ from the average return (in the case of historical standard deviation) or expected return (in the case of
expected standard deviation). The more individual returns differ from the average or expected return, the bigger the
standard deviation and, hence, the greater the risk. Equation 15.1 is used to calculate standard deviation of historical
returns.
Standard Deviation of Historical Returns

n (15.1)
2
œt 1
Rt  AR
T 
n

Where:
σ = the standard deviation of returns
Rt = the investment return in period t
AR = the average return
n = the number of periods

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The numerator on the right-hand side of the equation is the sum of the squared deviations between the actual
returns and the average return. The larger the deviation from the average return, the bigger its contribution to
the standard deviation. The denominator is simply the number of periods over which the average return has been
calculated.
Why are the individual return deviations squared? The reason has to do with how the average return is calculated.
If the deviations were not squared, the result would be meaningless, because the average of the deviations not
squared would be zero. By squaring the individual return deviations, the units of the final figure inside the square
root sign is percent squared, which is a different unit of measurement from the return figures upon which it is based.
Taking the square root of this squared number (the squared number is known as the variance of returns) converts it
into the standard deviation of return, which is expressed in the same units as return.
We’ll show you how to calculate standard deviation using the mutual fund data in Table 15.1.

Table 15.1 | XYZ Equity Fund Returns

Year Return (%)

1 49.36
2 15.67
3 -7.17
4 -8.78
5 26.51
6 11.15
7 25.38
Average Return 16.02

The annual standard deviation of the XYZ Equity Fund for the years 1–7 is calculated as follows:
2 2 2 2 2 2 2
49.36  16.02 15.67  16.02 7.17  16.02 8.78  16.02 26.51  16.02 11.15  16.02 25.38  16.02
T 
7

1,111.5556 0.1225 537.7761 615.04 110.0401 23.7169 87.6096


7

2,485.8608

7

 355.1229714
 18.84%

The seven-year annual standard deviation of the XYZ Fund was 18.84%.
The previous example showed how to calculate the standard deviation using annual returns, in which case the
standard deviation is an annual standard deviation. Standard deviations, however, can be calculated using returns
that cover any time period. If, for example, the standard deviation is calculated using monthly returns, then the
standard deviation is a monthly standard deviation, that is, the average deviation of monthly returns from the
average monthly return.
If the standard deviation is calculated using anything other than annual returns, it is often annualized so that it can
be compared to the standard deviation of other investments, which may or may not have been calculated using
similar time periods.

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Equation 15.2 is used to annualize the standard deviation when it has been calculated using anything other than
annual returns.
Annual Standard Deviation Formula
TAnnual  T q k (15.2)

Where:
k = the number of return periods in a year

To calculate the annualized standard deviation from the monthly standard deviation, for example, the monthly
standard deviation is multiplied by the square root of 12.
For example, if the monthly standard deviation of an investment is 3.93%, the annualized standard deviation
is 13.61%.
TAnnual  3.93% q 12

 3.93% q 3.4641

 13.61%
While it is a very common measure of risk, the standard deviation gives a fairly good indication of the dispersion
of returns only when returns are (or are approximately) normally distributed. A return distribution is a graphical
depiction of the potential returns plotted against their probability of occurrence. The normal distribution is the
familiar bell-shaped curve (see Figure 15.1).

Figure 15.1 | Normal Distribution

Probabilities

Returns

If returns are normally distributed, then the following relationships hold:

• Approximately 68% of all returns lie within one standard deviation of the average or expected return.
• Approximately 95% of all returns lie within two standard deviations of the average or expected return.
• Approximately 99% of all returns lie within three standard deviations of the average or expected return.

The normal distribution shown in Figure 15.2 illustrates these relationships.

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Figure 15.2 | Normal Distribution

-3σ -2σ -1σ AR +1σ +2σ +3σ

68.26%

95.94%

99.74%

For example, if the return on the XYZ fund in Table 15.1 were normally distributed with an average annual return of
16.02% and a standard deviation of 18.84%, we would expect to find that:
• 68% of all annual returns lie between -2.82% and 34.86% (equal to the average return +/- one standard
deviation)
• 95% of returns lie between -21.66% and 53.70%
• 99% of returns lie between -40.50% and 72.54%

BETA
Standard deviation measures the total risk of a security or portfolio. As noted earlier, total risk can be broken down
into systematic risk and unsystematic risk. Beta is a measure of the systematic risk of an investment. While it can
be calculated for any type of investment, beta is usually calculated for equity securities or a portfolio of equity
securities, such as an equity mutual fund. (For the rest of this section the term security is used to denote an equity
security or portfolio.)
Beta is a measure of the relative risk of a security compared to the risk of the overall market, which is usually taken
to be a broad market index of securities. The beta of a security can be calculated relative to any market index. For
example, the beta of a mutual fund is often calculated relative to its benchmark index, which could be a broad
market index such as the S&P/TSX Composite Index or the S&P 500 Index, or a narrow-based index, such as one of
the S&P/TSX sub-indexes. No matter what index is used, the interpretation is the same: the beta measures the risk
of the security relative to the index.
By definition, the index has a beta of 1. Thus, securities with a beta greater than 1 have more systematic risk than
the market, and securities with a beta less than 1 have less systematic risk than the market. All else being equal, the
greater the beta, the greater the risk of the security relative to the risk of the market. Technically, betas can be any
number, positive or negative, but, when calculated relative to a broad-market index, it is rare to find any security
with a negative beta, or with betas exceeding 2 or 3.

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Historical betas, which are often taken as an expectation of future betas, are calculated using simple regression
analysis. The analysis involves many different calculations and is usually performed on a computer by a statistical
software package, or even by some spreadsheet applications such as Microsoft Excel.
Simple regression analysis is a statistical technique that determines the linear relationship between two variables
from historical data. One variable, known as the independent variable, is assumed to influence the dependent
variable. When calculating the beta of a security, the independent variable is the historical return on the market
index and the dependent variable is the return on the security.
If values for the market and security return data are plotted on a graph, with the index-return data on the x-axis and
the security-return data on the y-axis, regression analysis produces an equation for a straight line that represents
the relationship between the data points. The slope of the straight line is the security’s beta. Figure 15.3 shows three
different values of beta calculated using three different sets of index/security return data.

Figure 15.3 | Three Different Calculations of Beta

Dependent Variable

Dependent Variable

Independent Variable Independent Variable

Dependent Variable

Independent Variable

In the upper-left panel of Figure 15.3, the return pairs form a band that slopes upward and to the right. The slope
of the line that best fits this relationship is positive, meaning that the security’s beta is positive. In the upper-right
panel, the return pairs form a negatively sloped band. The slope of the line that best fits this data is negative, and
therefore the security’s beta is negative. Finally, in the lower panel, the return pairs do not exhibit any consistent
relationship, and the best fitting line is a horizontal one, with a slope, and hence beta, of zero.
However, unless the security’s returns have moved in perfect lockstep with the index’s returns, the security’s beta
will not be a perfect representation of the relationship between the variables. That is, if past values of the market
index’s returns are plugged into the regression equation, the return on the security predicted by the equation will

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not equal the actual value of the security return at any given time. If a security’s returns move in perfect lockstep
with the index’s returns, then the security is said to be perfectly positively correlated with the index. This does not
necessarily mean, however, that the security has a beta of 1.
Therefore, regression analysis must also provide a measure of how accurately the regression equation describes
the relationship between the return on the market index and the return on the security. To determine how well
the regression line fits the actual data, the regression analysis calculates the percentage of the variability in the
security’s returns (as measured by the security’s variance) that can be explained by the variability in the market
index’s returns. This value is known as the coefficient of determination or R-squared. It can range from 0 to 1.
• A value of 0 means that the return on the security or portfolio and the return on the market index are unrelated
and that none of the variability in the security or portfolio is explained by the variability in the market index. In
this case, the beta will also be 0.
• A value of 1 means that the return on the security is perfectly correlated (either positively or negatively) with
the market index and therefore all of the variability is explained by the variability in the market index. In this
case, the beta can be any value other than 0.

The value of a security’s R-squared is closely related to the unsystematic risk of the security. The greater the
security’s unsystematic risk as a proportion of its total risk, the smaller the R-squared, and vice versa. In other
words, the greater the unsystematic risk of the security or portfolio, the smaller the proportion of the total risk that
is explained by the market index.
The beta of a portfolio of securities is simply a weighted average of the individual security betas (see Equation 15.3).
The Beta of a Portfolio of Securities
n (15.3)
CS  œw
i 1
i q Ci

Where:
wi = the proportion of the portfolio invested in security i
Ei = the beta of security i

For example, a portfolio has:

• 50% of its assets invested in a security with a beta of 1.3
• 25% of its assets in a security with a beta of 0.9
• 25% of its assets in a security with a beta of 1.1

CS  0.5 q 1.3 0.25 q 0.9 0.25 q 1.1

 0.65 0.225 0.275

 1.15

The beta of the portfolio is 1.15.

MEASURES OF DOWNSIDE RISK

The problem with standard deviation as a measure of risk is that it penalizes upside volatility as well as downside
volatility. That is, an investment that has posted several greater-than-average returns – which most investors
would consider a good thing – will have a large standard deviation. Based on this alone, the investment would be
considered risky.

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Therefore, a number of risk measures have been developed to analyze the downside volatility of an investment,
which is the type of volatility most investors are concerned about. These include the semi-deviation, which is similar
to the standard deviation except that only returns below the average return are included in the calculation and in
the probability of loss.
If all investment returns were normally distributed, the risk rankings using measures of downside risk would be no
different from rankings based on measures of absolute risk. But since some investment returns are not normally
distributed, the focus on downside risk becomes all the more important.

HOW CAN DIVERSIFICATION REDUCE INVESTMENT RISK?

A fundamental principle of modern portfolio theory is that an investor may reduce the unsystematic risk of
a portfolio by owning a diversified portfolio of investments, but that systematic risk cannot be reduced by
diversification alone. Diversification works because, with an adequate number of investments in a portfolio, the
unsystematic risks of individual securities tend to cancel each other out. In one period, a negative return on one
investment that is independent of the market return will likely be offset by a positive return in another security that
is also independent of the market return. The mathematical concept behind these offsetting returns is known as
correlation.

DIVERSIFICATION AND CORRELATION

Diversification is intimately related to the concept of correlation. As Harry Markowitz showed in his seminal work
on portfolio theory, the risk of a portfolio of securities depends not only on the risk of the individual securities, but
also on the correlation coefficient of each pair of securities’ returns.1
The correlation coefficient (or just correlation) between two securities measures the strength of the relationship
between their returns. That is, it is a measure of the degree to which the securities’ returns deviate from their
expected return at the same time. The correlation coefficient can have a value between or equal to +1.0 and -1.0.
• When two securities have positive correlation, a positive return on one security is usually accompanied by a
positive return on the other. The closer the correlation is to +1.0, the more likely it is that the returns will both
be either positive or negative during any given period.

• When two securities have negative correlation, a positive return on one security is usually accompanied by a
negative return on the other. The closer the correlation is to -1.0, the more likely it is that the return on one will
be positive and the return on the other will be negative during any given period.

• When two securities have zero correlation, their returns are independent and a positive return on one may
coincide with either a positive or a negative return on the other.

A correlation of +1.0 indicates that the returns on the two securities move together in a perfectly linear fashion. This
does not mean that the two securities’ returns are exactly the same all the time; it simply means that the return on
one can be represented as a linear function of the return on the other.
For example, if the return on one security always increases by 1.5 percentage points for a 1.0 percentage point
increase in another security’s return, the two securities have a correlation of +1.0. Likewise, two securities will
have a correlation of +1.0 if the return on one of them always increases by 2.0 percentage points for every
1.0-percentage-point increase in return on the other.

1
Markowitz, Harry M., “Portfolio Selection,” The Journal of Finance, Vol. 7 (1952): 77–91.

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A correlation of -1.0 indicates that return movements are in perfect linear opposition to one another. Again, it does
not mean that the returns always offset each other. For example, two securities have a correlation of -1.0 if the
return on one security always increases by 1.0 percentage point for a 2.5-percentage-point decrease in the other.
If two securities are less than perfectly positively correlated, there will be times when a greater-than-expected
return on one occurs when there is a less than expected return on the other. These return deviations produce
volatility in individual securities, but this volatility can be cancelled out when the securities are held together in a
portfolio.
Diversification benefits result when securities that are less than perfectly positively correlated are combined in a
portfolio. In this case, the risk of the portfolio, as measured by its standard deviation, will be less than the weighted
average of the securities’ standard deviations. The expected return, however, will always be equal to the weighted
average of the securities’ expected returns, no matter what the correlations are. In other words, it is possible to
lower the portfolio’s risk without giving up any of the portfolio’s expected return. The ultimate in diversification
comes when securities are perfectly negatively correlated, that is, when their correlation coefficient is equal to -1.0.
Unfortunately it is not easy to find securities that are negatively correlated, let alone perfectly negatively correlated,
especially among the securities that the typical investor owns. But as long as securities are less than perfectly
positively correlated – which most are – then portfolio risk can be reduced.

EFFICIENT AND NAIVE DIVERSIFICATION

Because most securities are less than perfectly positively correlated, a client may reduce the risk within a portfolio
simply by investing in a number of securities. But how should he select these securities? Are some combinations
better than others?
If he chooses securities randomly, without regard to their particular risk and return characteristics, the resulting
portfolio will benefit from what is called naive diversification. That is, the portfolio’s risk will be lower than the
average risk of the securities in the portfolio simply because the returns on the securities are, in all likelihood, going
to be less than perfectly positively correlated.
In the same paper in which he showed the importance of correlation, Markowitz also introduced a theory of
efficient diversification. Markowitz called a portfolio efficient if it provided the highest expected return for a given
level of risk. He developed a mathematical technique known as quadratic programming that allowed him to identify
a set of efficient portfolios, which is called the efficient frontier.
The efficient frontier has been an important marketing tool for many mutual fund companies and investment
dealers. It is often used to show risk-averse investors the benefit of adding some riskier investments to their
portfolio in order to increase their expected return without increasing the risk in their portfolio.

DIMENSIONS OF ASSET CLASS DIVERSIFICATION

Most efficient frontiers are built using the return and risk of asset classes rather than of individual securities. Typical
asset classes include equity securities, debt securities and cash. Recently, hedge funds have been recognized as an
important asset class, and more esoteric investments such as infrastructure investments and private equity have
become popular. In any case, investors rarely own “asset classes” – they own individual securities or funds that focus
on a particular part of the asset class. Thus, when a client is investing in individual securities or funds, it is important
that she diversify across the entire asset class, otherwise she will find her investments are too concentrated in a
particular area and that the diversification benefits are not as great as expected.
Equity securities can be diversified along the lines of geography, market capitalization and style. Diversifying by
geography means investing internationally. Market capitalization diversification means investing in small, medium
and large companies. Diversifying by style means investing in both value stocks and growth stocks.

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Debt securities can be diversified along lines such as geography, term to maturity and credit risk, among others.
Diversifying by term to maturity means investing in both long- and short-term bonds, which act differently for given
changes in interest rates. Diversifying by credit risk means investing in bonds with different credit ratings.

“DIWORSIFICATION”
As noted earlier, there is a limit to the benefits an investor can expect from diversification. That limit is determined
by the amount of systematic risk in the portfolio. Once all of the unsystematic risk has been removed, there are
essentially no benefits to adding more securities to the portfolio. The portfolio has reached a point where adding
more securities simply adds to the cost of maintaining the portfolio (executing trades, monitoring existing positions,
and so on) without providing any real benefits. Adding securities to the portfolio to the point where the risk-return
trade-off is worsened is sometimes called “diworsification.”
So the question asked by many investors is “How many securities do I need to ensure my portfolio is adequately
diversified?” Several studies have examined this issue, with a focus on the number of U.S. stocks needed to reduce
the unsystematic risk of an equity portfolio.2, 3 A study by Cleary and Copp looked at this issue from a Canadian
perspective.4 They found that during a 13-year period, about 66% of the total risk of a random stock could be
eliminated by combining all 222 stocks they looked at into an equally weighted portfolio. They used the risk of this
portfolio as the benchmark when examining the degree to which risk could be reduced by owning a portfolio rather
than a random single stock.
Cleary and Copp then constructed smaller, equally weighted portfolios holding 10, 20, 30, 50, 90 and 200 stocks.
They found that the 10-stock portfolios achieved about 68% of the risk reduction of the 222-stock portfolio, while
the 20-, 30-, 50-, 90- and 200-stock portfolios achieved 78%, 84%, 90%, 95% and 99.6%, respectively, of the risk
reduction.
Interestingly, research seems to indicate that, at least from a U.S. perspective, an even larger number of stocks are
needed to fully realize the benefits of diversification.5 Nevertheless, all of these results substantiate the theory that
diversification does indeed reduce total risk. Figuring out how many stocks to own, however, will depend on how
much of the total risk an investor wants to reduce and how many stocks an investor can “afford” to buy given the
size of his portfolio and its allocation to equities.

HOW CAN USING OPTIONS REDUCE INVESTMENT RISK?

While diversification is effective at reducing and even eliminating the unsystematic risk of a client’s portfolio, it is
not able to reduce systematic risk of either the portfolio as a whole or of an individual security. Reducing systematic
risk may be desirable for a number of reasons. A client might want to reduce her exposure to a single security or
even to a number of them. While at times it might be best simply to sell the securities, there are other times when
only temporary risk reduction is required. In these cases, it may be beneficial to consider the use of derivatives.
Derivatives are financial instruments whose value is derived from another security. The most common types of
derivatives available to the average retail investor are options and futures. The next few sections of the chapter
focus on how these instruments can be used to reduce the total risk of a security or portfolio of securities. Although
options and futures are both considered derivatives, the way they reduce risk is quite different.

2
Newbould, G.D., and P.S. Poon, “The Minimum Number of Stocks Needed for Diversification,” Financial Practice and Education, Vol. 3
(Fall 1993): 85–87.
3
Statman, M., “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis, Vol. 22 (September 1987):
353–63.
4
Cleary, Sean, and David Copp. “Diversification with Canadian Stocks: How Much is Enough?” Canadian Investment Review, Fall (1999): 21–25.
5
Domian, Dale, David Louton and Marie Racine, “Diversification in Portfolios of Individual Stocks: 100 Stocks are Not Enough,” Financial
Review, November 2007.

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Although derivative strategies are very effective risk management tools, there are certain constraints that may
prohibit an advisor from offering them to his clients. First, the advisor must work for a firm that is a member of the
Investment Industry Regulatory Organization of Canada (IIROC) and licensed to deal in options or futures or both.
Second, the advisor must be licensed to deal in options or futures, or both, which means he must have successfully
completed either the Derivatives Fundamentals Course (DFC) and the Options Licensing Course or the Derivatives
Fundamentals and Options Licensing Course (DFOL) for options licensing, or the DFC and the Futures Licensing
Course for futures licensing; all of these programs are offered by CSI Global Education Inc. Finally, the advisor’s
clients must be approved by the advisor’s firm to trade options or futures or both, which may not be the case for
some clients.

OPTION BASICS
Table 15.2 reviews the rights and obligations of different option positions. The following discussion provides detailed
information on how options work and can be used to protect a client’s investments.

Table 15.2 | A Stock Option Contract’s Rights And Obligations

Call Option Put Option

Long Position Right to buy the stock Right to sell the stock

Short Position Obligation to sell the stock, if called Obligation to buy the stock, if called
upon to do so upon to do so

The price that an option buyer pays to the option writer (seller) for the right to buy or sell the underlying asset is
called the premium. The premium is always quoted on a per unit basis, which means, for example, that the premium
quote for a stock option is the premium for each share of the underlying stock. To calculate the total premium for a
contract, multiply the premium quote by the option’s trading unit (see below).
The size of the premium is determined in a competitive marketplace. It takes into account many different factors,
the most important of which are the relationship between the exercise price and the market price of the underlying
asset, the expected volatility of the underlying asset’s price, and the time left until the option expires.
An option’s trading unit is the standard number of units of the underlying asset used to determine the total dollar
value of the option. All stock options in North America, for example, have a trading unit of 100 shares. This means
that the holder of one call option has the right to buy 100 shares of the underlying stock, while the holder of one
put option has the right to sell 100 shares of the underlying stock.
An option that can be exercised at any time up to the expiration date is called an American-style option. If the
option can be exercised only at the expiration date, it is called a European-style option. All stock options in North
America are American-style options.
Between the opening transaction (either the initial purchase or the writing of an option) and the option’s expiration
date, one of three events may take place.
First, the option may be offset before it expires, which, in effect, cancels the position. A long option is offset by
the sale of an equivalent option. A short option is offset with the purchase of an equivalent option. Offsetting
transactions are known as closing transactions.
Second, the option may be exercised. For the owners of call options, this means buying the underlying asset at the
strike price from the call option writer. For put option holders, it means selling the underlying asset at the strike
price to the put option writer.

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The option owner will exercise the option only if it is in his financial interest to do so, which means that the option
must be in-the-money.
• A call option is considered in-the-money if the market price of the underlying asset is higher than the option’s
strike price. If it is, the owner of the call option can exercise the right to buy the underlying asset at the strike
price and then immediately sell it at the higher market price.
• A put option is considered in-the-money when the market price of the underlying asset is lower than the
option’s strike price. If it is, the put owner can exercise the right to sell the underlying asset at the higher strike
price and immediately buy it back at the lower market price.

When the owner of an option exercises it, a writer of an equivalent option is assigned the contract. A call writer
is assigned to deliver the underlying asset to the call owner in exchange for payment. A put writer is assigned to
accept delivery of the underlying asset from the put owner in exchange for payment.
The in-the-money portion of a call or put option is known as the option’s intrinsic value. When an option’s premium
is worth more than its intrinsic value, it is said to have time value. Time value is equal to the option’s premium
minus its intrinsic value.
The third outcome that could occur is that the option could expire worthless. Option holders have rights, not
obligations. If it is not in the option owner’s financial interest to exercise the option, he does not have to do so. The
option owner will not exercise the option if it is out-of-the-money or at-the-money.
• A call option is considered out-of-the-money if the market price of the underlying asset is lower than the
exercise price. It does not make financial sense for a call option owner to buy at the exercise price when the
underlying asset could be bought at the lower market price.
• A put option is considered out-of-the-money if the market price of the underlying asset is higher than the
exercise price. It does not make sense for the put option owner to sell at the exercise price when the underlying
asset could be sold at the higher market price.
• Both calls and puts are considered at-the-money if the market price of the underlying asset is equal to its strike
price. Since there is no advantage to exercising an at-the-money option, particularly given the commission costs
of buying or selling most underlying assets, it will be left to expire.

Table 15.3 summarizes in-the-money, at-the-money and out-of-the-money options.

Table 15.3 | In-The-Money, At-The-Money And Out-Of-The-Money Options

Call Options Put Options

In-the-Money Strike Price < Underlying Asset’s Strike Price > Underlying Asset’s
Market Price Market Price

At-the-Money Strike Price = Underlying Asset’s Strike Price = Underlying Asset’s

Market Price Market Price

Out-of-the-Money Strike Price > Underlying Asset’s Strike Price < Underlying Asset’s
Market Price Market Price

Most of the discussion so far has assumed that when an option is exercised it always results in physical settlement,
meaning that the underlying asset is exchanged between the two parties. Not all options work this way, however.
Some have what is known as a cash settlement feature. If an option is cash settled, it simply means that when an
option is exercised the holder of the short position delivers to the holder of the long position an amount of cash
equal to the option’s intrinsic value multiplied by the option’s trading unit multiplied by the number of contracts.

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The economic impact to the holders of long and short positions is essentially the same for both physically and cash-
settled options. The most popular cash-settled options are those based on equity indexes.

OPTION MARKETS
Options trade on exchanges and over the counter. While there are several differences between the two markets,
the biggest distinction is that in the over-the-counter (OTC) market, contracts are privately negotiated agreements
between the buyer and seller, who are free to set contract terms as they see fit. In the exchange-traded market,
however, contracts are standardized by the exchange that lists them, meaning all the terms except for the price
are pre-established. This standardization allows for the offsetting of contracts among different market participants
without the need to negotiate directly with the original counterparty to the trade.
The over-the-counter market is primarily the domain of large financial institutions, institutional investors and large
corporations. Retail investors, including most high-net-worth individuals, cannot normally access the OTC market
and must use the exchange-traded market to establish any of the strategies that will be discussed in the next
section.
Exchange-traded options are available on a wide variety of underlying assets, including individual stocks, stock
indexes, interest rates, futures contracts and more. For the advisor’s clients, the most useful contracts would likely
be those based on individual stocks, stocks indexes, bonds and interest rates.
In Canada, options are available on most large cap stocks, the S&P/TSX 60 Index and several Canadian iShares
(which are based on S&P/TSX indexes), including the iShares S&P/TSX 60 Index ETF, the iShares S&P/TSX Capped
Energy Index ETF, the iShares S&P/TSX Capped Financials Index ETF, the iShares S&P/TSX Global Gold Index
ETF, the iShares S&P/TSX Capped Materials Index ETF, and the iShares S&P/TSX Capped Information Technology
Index ETF.
In the U.S., there are options on hundreds of individual stocks and exchange-traded funds (ETFs) and several dozen
stock indexes. There are also options on U.S. Treasury yields.

PROTECTIVE PUTS ON INDIVIDUAL STOCKS

The most basic risk reduction strategy using options is the protective put. A protective put consists of a long
position in an underlying asset and a long put option on the underlying asset. Buying a put to hedge an investment
is like buying insurance to protect its value, and the decision process to use this strategy is similar to the process one
would go through when buying insurance.
With the choice of options available to retail clients, protective puts may be established on individual stocks or on a
portfolio of stocks using index options. The remainder of this section focuses on protective puts on individual stocks;
a discussion of protective puts on stock portfolios is in the section that follows.
Protective puts may be purchased when the stock is purchased or at any time afterwards. When an investor buys
puts after buying the stock, it is usually to protect an unrealized profit on the stock. The long put gives its holder
the right to sell the underlying stock at a fixed price on or before the expiration date. This right sets a minimum
sale price for the investor’s stock position over the life of the option, no matter how low the stock price falls. The
minimum sale price equals the strike price of the option, but the net sale price is the strike price minus the cost of
the option. For example, if an investor buys a put option with a strike price of $50 for $3, the locked-in net sale
price is $47 ($50 – $3).

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EXAMPLE
Buying Protective Puts
Suppose that several months ago an investor bought shares of ABC stock at $25. The market price of these
shares has risen to $35, and the investor is wondering if she should sell the stock and lock in the $10 per share
unrealized profit, or hold on in the hope of an even higher price. The investor will regret the decision to sell now if
the price of the shares continues to rise after the sale. On the other hand, the investor will regret the decision not
to sell if the price of the shares falls, eroding the unrealized profit.
A protective put purchase might be the answer to helping the investor avoid such regrets in both situations.
Suppose the following put options on ABC stock are available:

Expiration Strike Price Premium

60 days $30.00 $0.45
60 days $32.50 $1.05
60 days $35.00 $2.15
60 days $37.50 $3.65
120 days $30.00 $1.00
120 days $32.50 $1.80
120 days $35.00 $2.90
120 days $37.50 $4.40

What should the investor do? In buying protective puts, the investor must consider the time to expiration, the
strike price and the option premium. Each of these is discussed in detail in the following sections.

TIME TO EXPIRATION
How long is the insurance protection needed? Investors usually decide to purchase protection because the stock
price is vulnerable to decreases during a particular period, probably related to some expected future event that
might lower the stock price. If, for example, an earnings report is scheduled for release in a few weeks, one month’s
worth of insurance may be sufficient to cover this event. If seasonal factors may increase the risk of the position
over the next two to three months, then at least 90 days’ worth of protection is warranted. If there is a pending
lawsuit that may not be resolved for more than a year, the investor should consider LEAPS, which will be discussed
later in this chapter.
Obviously, the longer-dated options will cost more on an absolute basis, all else being equal. But if the investor is
buying at-the-money options, shorter-term options are more expensive for each day of protection they offer. For
example, the 60-day ABC $35 put in the example above costs $2.15, or about 3.6¢ per day of protection, whereas
the 120-day $35 put costs $2.90, or about 2.4¢ per day. This represents a saving of 33% per day.

STRIKE PRICE
The choice of a strike price determines what the investor’s “deductible” will be. If the investor buys an out-of-the-
money option, the deductible is the amount by which the option is out-of-the-money and the amount that the
investor’s unrealized profit will be reduced if she exercises the put option and sells the stock. If the investor decides
to buy a $32.50 put, the $2.50 that the option is out-of-the-money is the deductible. The unrealized profit will
be reduced by this amount if the investor exercises the option. At-the-money options have no deductible. In-the-
money options have a negative deductible, which means that the unrealized profit is increased by the in-the-money
amount.

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There is no one right answer to the question of which option to choose. The 60-day $32.50 put costs less than
half the 60-day $35 put, but the amount of locked-in profit is lower by $1.40 (the strike price is $2.50 lower, but
the cost of the put is $1.10 less). This may be acceptable to the investor who paid $25 for the stock. The $30 put,
although quite inexpensive, represents “disaster” insurance, since the stock would have to fall substantially before
this put became in-the-money. However, for $0.45, the investor can make sure that all of the unrealized gain does
not disappear as a result of a sudden drop in the stock price.

OPTION PREMIUM
How much should the investor be prepared to pay for insurance? Options with a longer time to expiration cost
more, all else being equal. Put options with a higher strike price (and therefore a smaller deductible) will also cost
more. But, given the time to expiration and the strike price, is $2.15 too much to pay for 60 days’ worth of insurance
on a $35 stock? Is $2.90 reasonable for 120 days’ worth of protection?
The prices of all of the ABC options imply a 40% annualized volatility. If they implied a volatility of 30%, the 60-day
$35 option would be worth $1.55 and the 120-day option would be worth $2.65. At a 50% implied volatility6, the
premiums would be $2.95 and $4.20, respectively. The higher the volatility estimate, the higher the premium for
the put. But the higher implied volatility also assumes a higher risk for the stock. Once again, each situation must be
weighed on its own merits. How many investors would pay $2.15 to insure a $35 stock for 60 days? If the investor
who bought ABC stock at $25 bought the stock only a week ago, it could easily go back down to $25 in a week, or
up to $45. In this case, the $2.15 might not seem excessive.
One of the paradoxes of buying protective puts is that, in hindsight, the strategy is never ideal. If the investor goes
ahead and buys the 60-day $35 put at $2.15 and the price of ABC drops to $25, the investor will probably regret not
having sold the stock when it was at $35. This would have locked in the $10 profit, and saved the cost of the option.
If, however, the price of the stock keeps going up, the investor may feel that buying puts was a waste of money.
Nobody ever knows the best strategy until after the fact. By purchasing puts, the investor can maintain a long stock
position, and profit from any further rise in ABC, while locking in all or part of the accrued profit. That is the value of
a hedge.

PROTECTIVE PUTS ON STOCK PORTFOLIOS

Establishing a protective put on a stock portfolio requires the use of stock index options. Before we delve into the
protective put strategy using stock index options, we’ll spend some time looking at how stock index options differ
from options on individual stocks.
Stock index options are similar to options on individual stocks. There are, however, at least three key differences.
First, index options, with a few exceptions, have a European-style exercise, which means they can be exercised only
at expiration. Second, index options are cash settled. The size of the cash settlement is equal to the intrinsic value
of the option multiplied by a multiplier multiplied by the number of contracts. Most index options have a multiplier
of $100. The final difference relates to how these instruments are used in conjunction with their underlying assets.
While an individual stock option can provide an investor with a perfect hedge, in almost all cases, stock index
options cannot provide perfect hedges. Investors who use stock index options as a hedge should be aware that a
perfect hedge cannot be achieved unless the investor’s portfolio has the same stocks in the same proportion as the
index upon which the option is based. This is very unlikely.
Index options can be used to help equity investors who wish to retain an existing portfolio, but are concerned that
while equity prices may decline in the near term, they will remain bullish over the long term. By purchasing stock
index put options, investors are, in essence, buying insurance to protect against equity price declines. If equity prices
do decline, the puts will rise in value and the profit can be used to help offset the portfolio’s paper losses. If, instead

6
The calculation of implied volatility is beyond the scope of the IMT course.

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of falling, equity prices increase, then the investor’s portfolio will still gain in value, although that gain will be offset
by the cost of the put premium.
Establishing a protective put with stock index options is popular among investors who retain a long-term bullish
view of the market and want to retain the equities in their portfolios. The protective put offers the investor an
alternative to liquidating all or some of the portfolio and then having to repurchase them when market conditions
warrant. This approach involves numerous transactions and is very costly. It also means forgoing dividends, has
possible tax implications and requires accurate market timing.
The first step in implementing a protective put strategy is to identify the underlying index with the best correlation
to the stock portfolio. For example, S&P/TSX 60 Index options would obviously be a much more suitable hedging
vehicle for a portfolio of blue chip Canadian stocks than S&P 500 Index options, even though the latter have much
greater liquidity. Once this correlation is established, the advisor must decide how many contracts to use in the
hedge, and at what strike price. These decisions will be based on the following considerations:
• the size of the portfolio in relation to the size of the option contract
• the sensitivity of the portfolio to the underlying index (beta)
• the degree of protection desired

If a stock portfolio has historically shown a tendency to have returns directly proportional to a stock index’s returns,
the portfolio’s beta will be close to 1. If the historical tendency is towards greater volatility relative to the index, the
portfolio’s beta will be greater than 1, and if volatility is found to be lower than the index, the portfolio’s beta will be
less than 1.

EXAMPLE
Buying a Protective Put on a Stock Portfolio
Assume that an investor is looking to protect a $500,000 portfolio of blue chip Canadian stocks for six months
using S&P/TSX 60 Index put options, which have a multiplier of $100. A historical analysis has revealed that the
portfolio has a beta of 1.2 relative to the S&P/TSX 60 Index. This means for every 1% change in the level of the
index, the portfolio is expected to change by 1.2%.
Once the beta has been determined, the number of contracts to use is based on formula 15.4.
Value of Portfolio q Portfolio Beta (15.4)
Number of Contracts 
Current Index Value q Contract Multiplier

If the S&P/TSX Index is currently at a level of 750, the investors must buy 8 contracts.
$500,000 q 1.2 $600,000
Number of Contracts   8
750 q $100 $75,000

Next, determine the degree of protection desired. This will be a function of the strike price. The higher the
strike price, the greater the amount of protection provided. Increased protection does not come without a
cost, however, because puts with higher strike prices will cost more than puts with lower strike prices, all else
being equal. Perhaps the best way to choose a strike price is to determine how much the investor is willing to
lose, based on the portfolio’s current value, if the index declines. The amount the investor will lose equals the
difference between the current level of the index and the strike price, plus the cost of the option.

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EXAMPLE
Cont'd
Suppose the following six-month options are available:

Strike Price Premium

650 $12.75
675 $18.85
700 $26.75
725 $36.50
750 $48.15

If the S&P/TSX 60 Index declined to 600 after six months, the investor would lose the following amounts,
depending on the strike price chosen and assuming the portfolio behaved as the beta suggested:

Strike Price Portfolio Loss Option Payoff * Option Cost Total Loss
650 $120,000 $40,000 $10,200 $90,200
675 $120,000 $60,000 $15,080 $75,080
700 $120,000 $80,000 $21,400 $61,400
725 $120,000 $100,000 $29,200 $49,200
750 $120,000 $120,000 $38,250 $38,250

At first glance it may seem obvious that the investor should “want” to lose the least amount of money, in which
case the six-month 750 put should be purchased. But this option costs the most amount of money up front, and
if the market were to go up rather than down, this money would be lost. Buying an option with a lower strike
price means a lower up-front cost, and a lower loss if the market goes up.

* For example: for the 650 strike price, the option payoff is calculated as: (650 – 600) × $100 multiplier × 8 contracts = $40,000

COVERED CALLS AS A HEDGE

Selling (writing) call options is usually an income-producing strategy. But it can also be used as a hedging
mechanism.
Suppose an investor holds shares in WXW stock, currently trading at $76, and believes this stock is set for a
correction over the next six to eight weeks. For one reason or another, however (perhaps because of a potential tax
liability, or maybe because he has an optimistic long-term view of the stock’s value), the investor is unwilling to sell
the shares. At the same time, the investor wants to take advantage of a possible trading opportunity over the next
few months.
Hedging a long stock position usually means purchasing puts. But some investors dislike buying options: they are,
after all, a wasting asset, and if the price of the underlying stock does not change by a sufficient amount, the puts
can lose much of their value or expire worthless. With WXW trading at $76, the two-month $75 calls are trading at
$4.50, and the two-month $70 calls at $7.70. Either of these could be written against a long stock position to take
advantage of the expected decline in the stock price. The choice of option depends on how bearish the investor is.

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If the investor decides to write the $75 calls at $4.50, he is now positioned to take advantage of a moderate fall in
the price of the stock. The $4.50 premium received acts as a cushion against a decline in the price of WXW stock.
Unlike the protective put, however, the protection is limited to the premium received.
If in 60 days WXW is below $75, the call will expire worthless and the profit on the option trade will be $4.50. The
investor has been insulated from a decline in the stock price to $71.50 (the stock fell from $76 for a loss of $4.50,
which is offset by the premium received).
It is possible that by the time the options expire, WXW will have fallen by more than $4.50, and this will result in a
loss on the overall position. For example, if the stock price is $70 at expiration, the stock position will show a $6 loss
and the short option will show a profit of $4.50, for a net loss of $1.50. The net loss becomes larger the lower the
stock price falls, but it will always be less than the loss on the stock position alone by the amount of the premium
received. If the investor wants to hold these shares over the long term, he may not mind seeing their value fall by a
limited amount in the short run, especially if he is realizing a profit on the option trade.
The investor does, however, have to worry about what will happen if his forecast for a lower stock price turns out to
be incorrect, and the price of WXW starts rising. Since the investor does not want to sell the shares, he will, at some
point, have to repurchase the call options. The short call’s upside break-even is $79.50 at option expiration ($75
strike price plus $4.50 premium received). If WXW is trading at $79.50 at expiration, the $75 calls should be trading
at $4.50 and could therefore be repurchased at a break-even price. But with a quick run-up in the price of the stock,
the investor might have to scramble to cover the short call position at a significant loss.
This short-term bearish investor could also consider selling in-the-money $70 calls at $7.70. This would be a more
aggressive position, since in order for him to realize the maximum profit possible on the options, the price of WXW
would have to fall below $70 within two months. Writing the $70 calls also leaves less room for error on the upside:
the option’s break-even stock price at expiration, if the stock starts to rise, would be $77.70, only $1.70 above the
current price of the stock. If the stock drops below the call’s strike price of $70, the profit potential on the option
will be $7.70, compared with only $4.50 for the $75 call. Table 15.4 summarizes the outcomes of the two covered-
call hedges.

Table 15.4 | Comparison of Two Different Covered Calls as a Hedge

Maximum Profit Maximum Profit Reached Downside Break-Even Upside Break-Even

on Option if Stock Price is: (on the Whole Position) (on the Short Call Only)

Write $70 call $7.70 Below $70 $68.30 $77.70

Write $75 call $4.50 Below $75 $71.50 $79.50

Note that the downside break-even gives the level below which the position as a whole will show a loss, whereas the
upside break-even stock price represents the level at which only the written option breaks even. Prices below the
downside break-even are those at which the losses on the underlying stock are greater than the gain on the written
option.
Writing call options to hedge a stock that is expected to fall is an alternative to purchasing puts. However, it is a
more aggressive and sophisticated hedging strategy than protective puts, and requires more attentive monitoring,
especially when the price of the underlying stock starts to rise. Table 15.5 summarizes some of the key differences
between buying protective puts and writing covered calls as a hedge strategy.

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Table 15.5 | Protective Puts Versus Writing Calls as a Hedge

Buying Protective Puts Writing Calls as a Hedge

Amount of Protection Offered Complete protection below put Limited to call premium
strike price received

Upside Potential Unlimited, less cost of put Limited

Position Initiated for a: Debit Credit

Result if Stock Price Remains Loss equal to time value of put Profit equal to time value of call
Unchanged purchased sold

COLLARS
Collars have grown in popularity as a hedging vehicle, probably because they provide all the protection offered
by a protective put, but usually do so without requiring any cash outlay. The notion of “no-cost” insurance sounds
appealing, although the “no-cost” assumption must be qualified.
Collars are used by investors who want to reduce the downside risk of an equity position, and who, in order to
obtain this protection, are willing to forgo some of the stock’s upside potential. Investors construct a collar by
purchasing an out-of-the-money put while simultaneously writing an out-of-the-money call. For example, an
investor who holds shares in YYZ stock, which is currently trading at $52, and who wants to minimize the stock’s
downside risk over the short term, could purchase a 60-day $50 put at $1.50 and sell a 60-day $55 call, also at
$1.50. The premium received from writing the call fully offsets the cost of purchasing the put, creating what is
known as a zero-cost collar. (It is not always possible to create a zero-cost collar. The cost of the collar depends on
where the stock price is in relation to the strike price of the options available on the stock. However, there is usually
a combination of strike prices that will yield a collar trading close to even money.)
The investor is now long the 60-day $50 put, so the downside risk is limited to $2, from the stock’s current price of
$52 to the put’s strike price of $50. On the other hand, by writing the $55 call, this investor has limited the upside
potential to $3, from the stock’s current price of $52 to the call’s exercise price of $55. (If the stock is above $55
the investor will be assigned on the short call option and will have to sell the shares at $55.) Since the investor
established the collar for even money, the overall position has $2 of risk and $3 of profit potential.
Table 15.6 shows the total value of the position at various stock prices at expiration.

Table 15.6 | Value of Collared YYZ Stock Position at Option Expiration

YYZ Stock Price Value of Value of Value of Collared Stock

at Option Expiration Long $50 Put Short $55 Call Position
$45.00 $5.00 $0 $50.00
$47.50 $2.50 $0 $50.00
$50.00 $0 $0 $50.00
$52.50 $0 $0 $52.50
$55.00 $0 $0 $55.00
$57.50 $0 ($2.50) $55.00
$60.00 $0 ($5.00) $55.00

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The numbers in Table 15.6 are presented in Figure 15.4.

Figure 15.4 | Value of Collared YYZ Stock Position at Option Expiration

$60.00

$57.50
Value per Share

$55.00

$52.50

$50.00

$47.50

$45.00 $47.50 $50.00 $52.50 $55.00 $57.50 $60.00

Stock Price at Option Expiration

The value of the position will not be less than $50 at option expiration. If YYZ is trading below $50 at or close to
expiration, the investor must decide whether to exercise the put option and sell the stock at $50, or liquidate the
long put position. In the latter case, the profit realized on the options will partially offset the unrealized loss on the
stock, but the investor will no longer be protected against any further decline in the price of YYZ stock.
If at or near expiration, YYZ is trading above $55, and the investor takes no action, the short call position will be
assigned and the investor will be forced to sell the shares at $55. If the investor still wants to own the shares, he
will have to repurchase or roll out the call to a different expiration month. Rolling out a short call option means
repurchasing the existing short call and writing another short call with a later expiration date. Any investor who
collars a long stock position should be fully aware of the obligations that a short call position entails.
Fortunately, because of option pricing dynamics, the risk-reward ratio (which equals the maximum risk divided by
the maximum reward) of a collared hedge tends to decrease as the expiration date of the options is pushed back.
For example, if the same YYZ stock is trading at $52, a one-year collar can be established by buying the one-year
$50 put at $4.20 and writing the one-year $60 call for $4.30. The investor establishes the collar for a small credit,
but more importantly, the strike price of the call option has been raised from $55 to $60.
The risk of the one-year collared hedge from the current stock price is therefore $1.90 – the possible $2 decline
from $52 to the put’s strike price of $50, minus the initial credit of $0.10. The reward potential from the current
stock price has been raised to $8.10 – the possible price increase from $52 to the call’s strike price of $60,
plus the initial credit of $0.10. Obviously the one-year collared hedge has a more favourable risk-reward ratio
(equal to $1.90/$8.10, or 0.235).
The investor could establish a two-year collar on YYZ by purchasing the $50 put at $5.75 and writing the $65 call
for $6.30, initiating the position for a credit of $0.55. The downside risk would then be limited to $1.45 and the
upside potential increased to $13.55, for a risk-reward ratio of 0.107. The lower risk-reward ratio of the two-year
collared hedge must be balanced with the increased time to expiration: the full upside of $13.55 will probably not
be realized before the full 24 months elapse.

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LEAPS
LEAPS stands for Long-term Equity AnticiPation Securities; these options are originally listed with the expiration
date three years away, in contrast to the maximum nine months until expiration for regular options. By using LEAPS
to create collars, investors can protect an unrealized gain in a stock position and defer the realization of their gains
until a later tax year. All LEAPS listed on Canadian and U.S. exchanges expire in January. An investor who in any
given year has a profitable stock position can lock in most of these gains by purchasing a collar that expires the
following January and thereby carry the gains and their tax liability into the following tax year.

TAX IMPLICATIONS
When a non-professional trader uses collars, the gross premium of the short call options (before subtracting
the premium of the long option) is recognized as a capital gain in the year the options are written. This may not
be significant when the options expire in January of the following year (for example, 20X2 LEAPS sold in 20X1),
assuming a capital gain is realized when the LEAPS expire. But if they expire in the second year (for example, 20X3
LEAPS sold in 20X1), the investor faces a taxable event in the year the options are sold, and this would not be
reversed or adjusted until two years later, if the option position is carried to expiration. In certain circumstances,
incurring this immediate tax liability is preferable to selling the stock outright and having to recognize a potentially
larger capital gain.

HOW CAN USING FUTURES CONTRACTS REDUCE RISK?

Option contracts have non-linear payoffs that allow buyers to walk away from their contracts when it is not in their
best interest to exercise them. This fundamental right is the reason the buyers must pay sellers to accept these
terms, and the non-linear payoff makes protective puts much like buying insurance on an asset.
Futures contracts, however, have linear payoffs because neither the buyer nor the seller may get out of their
contracts (except through an offsetting transaction), which is why, as the next section discusses, it does not cost
anything to enter into a futures contract.

FUTURES BASICS
A futures contract is a legally binding agreement traded on a regulated futures exchange. All futures contracts have
a buyer and a seller and an expiration date. The buyer of a futures contract promises to take delivery of a specified
amount of an underlying asset on a certain date in the future (usually just after the last trading date) at an agreed-
upon price; the seller promises to make delivery of the asset on the same terms.
The agreed-upon price is known as the entry price or the delivery price and is determined when the buyer and seller
enter into the contract. No matter what happens to the price of the underlying asset between the time of entering
into the contract and the delivery date, the buyer and the seller must buy and sell the underlying asset at that price
on the specified date if their futures position is intact.
Like option contracts, however, either the seller or the buyer, or both, can offset their positions by entering into an
offsetting transaction in the same futures contract. The profit or loss when a position is offset equals the difference
between the offset price and the original entry price. If the offset price is higher than the original entry price, a long
position earns a profit and a short position suffers a loss. If the offset price is lower than the original entry price, a
long position suffers a loss and a short position earns a profit.
Futures contracts are standardized with respect to delivery time and place, and the quantity and the quality of the
underlying asset. Some futures contracts are cash-settled by a payment equal to the difference between the cash
price of the underlying asset on the future date and the entry price, while some are settled by the physical delivery
of the underlying asset from the seller to the buyer.

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Similar to terminology used in the stock market, the buyer of a futures contract is said to be long the futures
contract, while the seller is said to be short the futures contract. Unlike the stock market, however, there is no need
to “borrow” a futures contract to short it. Anyone can buy or sell a futures contract at any time.
Unlike option contracts, the initial value of a futures contract to both buyer and seller is zero. The contract only
gains value as the futures price changes. If the futures price goes up, the value of a long position goes up and the
value of a short position goes down. The reverse is true if the futures price goes down. Because they have no value
at initiation, there is no cost to enter into a futures position. Both the buyer and the seller, however, must deposit
and maintain margin in their futures accounts. Unlike margins on securities (which are counterpart to the maximum
loan value that a dealer may extend to a client to purchase a security), futures margins are amounts of money that
a customer must deposit with a broker to provide a level of assurance that the financial obligations of the futures
contract will be met. In effect, futures margin represents a good faith deposit or a performance bond.
The minimum margin rate for a client who wishes to establish a position in a futures contract is set by the futures
exchange, but a member firm may impose higher margin rates on its clients. The member firm, however, may not
charge the client less than the exchange’s minimum requirements.
There are two levels of margin that are used in futures trading – original and maintenance margins. Original or initial
margin represents the required deposit when a futures contract is entered into. Maintenance margin is the minimum
balance for margin required during the life of the contract.
Futures positions are marked-to-market daily, which means that at the end of each trading day the long makes a
payment to the short or vice versa, based on the change in the price of the contract that day. If the price went up,
the short pays the long; if the price went down, the long pays the short.

REDUCING PORTFOLIO RISK WITH STOCK INDEX FUTURES

For a long time, investors had to accept the idea that the systematic risk of a stock portfolio could not be
eliminated. This all changed with the introduction of stock index derivatives a few decades ago. The proliferation of
stock index futures contracts has allowed investors to eliminate the systematic risk of a stock portfolio.
Any asset with no risk, by definition, earns the risk-free rate of return. Since a portfolio with no risk should earn
the risk-free rate, why do investors have to eliminate risk with futures contracts? In other words, why do they not
invest in zero-risk Treasury bills to start with? The answer to this question is that investors may wish to eliminate
risk for only short periods of time when, for example, they anticipate a lot of volatility in the market. Switching their
portfolio holdings from risky to risk-free assets and vice versa can be time consuming and very costly due to the
numerous transactions involved. Thus, futures contracts represent ideal vehicles for hedging purposes.
The first step in implementing a hedge is to determine the total dollar value of the portfolio of stocks at risk. The
second step is to take the opposite position in the futures market using a quantity of stock index futures that best
replicate the portfolio. The investor hopes that losses in the portfolio of stocks – assuming the market declines – will
be offset by gains in the index futures.
Determining the quantity of index futures contracts needed for a hedge requires knowledge of the relationship
between returns on the portfolio being hedged and returns on the index that underlies the futures contract used in
the hedge. This relationship is captured by the portfolio’s beta.
Determination of the number of contracts to use in a hedge must take into account the beta. If it does not, an
investor may find that the portfolio is under-hedged (in cases where the portfolio’s beta is greater than 1) or over-
hedged (in cases where the portfolio’s beta is less than 1).
While the use of beta in determining the number of contracts to use in a hedge cannot guarantee elimination of the
risk of being under- or over-hedged (since beta is usually based on historical data and can change going forward),
it can give the investor some level of assurance that potential losses from a mis-hedged portfolio will be minimized.
The number of contracts an investor should use to hedge a particular portfolio is shown in Equation 15.5.

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Number of Contracts Needed to Hedge a Stock Portfolio

MV S q C (15.5)
H 
Iqm

Where:
MVρ = market value of the stock portfolio to be hedged
β = the portfolio’s beta relative to the index that underlies the futures contract
I = stock index futures price
m = stock index futures multiplier

EXAMPLE
Selling Futures Contracts to Reduce Risk
Assume that a client has a $600,000 equity portfolio with a beta of 1.25 relative to the S&P/TSX 60 Index.
The client is concerned about the possibility of weakness in the overall Canadian equity market for the next six
months and would like to eliminate all of the risk associated with her equity portfolio. She doesn’t want to sell
her stocks, however, as she thinks the decline will last for only six months and after that she wants to be invested
in equities again. Selling all her shares would also trigger a significant tax liability in the current year.
The client therefore agrees to sell six-month S&P/TSX 60 Index futures, which have a multiplier of $200 and are
currently trading at 750. With the S&P/TSX 60 Index currently at 740, the investor needs to sell 5 contracts.

$600,000 q 1.25
H 
750 q $200
$750,000

$150,000
 5
Suppose the client goes ahead and sells the futures contracts. Six months later the investor’s prediction turns
out to be correct and the S&P/TSX 60 Index is down 10% to 666. The client’s portfolio of stocks, meanwhile, has
gone down 12.5%, or $75,000, and is now worth $525,000.
The futures contracts are about to expire and they are also trading at 666. The client, feeling that the worst is
now behind her, offsets the futures at their current price, thereby realizing a profit of $84,000.
Profit = (750 – 666) × $200 × 5 contracts = $84,000

In the above example, the decline in the value of the portfolio was completely offset by the gain in the short futures
position. (The client actually profited by $9,000 because the gain on the futures position exceeded the loss on
the stock portfolio by $9,000. This, in conjunction with the dividends the client likely received on the stocks in her
portfolio, represents the “risk-free” return she earned by holding what was, in effect, a risk-free portfolio.) The beta’s
“prediction” that gains or losses in the portfolio would be 25% greater than in the S&P/TSX 60 Index came true.
If, instead of falling, equity prices rose, gains in the portfolio would have been to a large extent offset by losses on
the short futures position. In effect, the price that the hedger has paid for downside price protection is to forgo (at
least as long as the hedge is in place) most, if not all, of the unexpected portfolio gains.
Also note that the client eliminated all of the risk in her equity portfolio or, to state it another way, reduced the risk
of her entire equity portfolio. There is nothing that requires her to make this decision. She could have easily hedged
only a portion of the portfolio. To determine the number of contracts to use in this situation requires inputting the

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dollar value of the portion to be hedged into the formula. For example, if the investor wanted to reduce the risk on
half of her portfolio, then the value $300,000 would have been used instead of $600,000 in the formula used to
calculate the number of contracts to sell.
She might have also wanted to simply reduce her exposure to the Canadian market by lowering her beta, which
at 1.25 is quite a bit higher than that of the overall market. In this case, she would have calculated the number of
contracts to sell by using the difference between her current beta and her target beta in the formula, rather than
just the current beta. For example, if she wanted to reduce her beta to 0.5, she would insert 0.75 (which equals
1.25 – 0.5) into the formula rather than 1.25.

HOW CAN USING CONTRACTS FOR DIFFERENCE (CFDs)

REDUCE RISK?
A contract for difference (CFD) is a type of cash-settled over-the-counter derivative contract with pricing closely
mirroring that of an underlying asset. As a potential hedging substitute for single stock futures, advisors and
investors might consider CFDs.7

HEDGING WITH CFDs

Short CFD positions can be used to hedge against long stock positions. If investors want to eliminate all the risk of a
long stock position, they merely have to sell the same number of CFDs.
For example, an investor owns 1,000 shares of XTY with a purchase price of $40 per share. The stock is currently
trading at $65.50, but the investor feels that the shares may be ripe for a setback over the next few months. The
investor does not want to buy put options on XTY because they are quite expensive, and writing calls will not
provide as much protection as the investor needs. In addition, the investor is quite confident that the shares will not
appreciate too much in value. Rather than just sell the stock and trigger a significant capital gain, the investor wants
to institute a hedging strategy that locks in the current value of the stock. As a result, the investor decides to sell
1,000 XTY CFDs at the current price of $65.50.
The CFDs will appreciate in value if the price of the shares decline as the investor predicts. Of course, the CFDs will
lose money if the shares appreciate in value, but since the investor owns the shares, the loss on the CFDs will be
offset by the gains on the stock held. Like futures contracts, the CFDs have locked in a sale price equal to the price
at which the CFDs were sold. Unlike futures contracts, however, the CFDs have no maturity date, so as long as the
investor can maintain the margin requirements imposed by the CFD provider, the investor can maintain the hedged
position indefinitely.

HOW CAN USING PRINCIPAL-PROTECTED NOTES (PPNs)

REDUCE RISK?
While an investment in a PPN in and of itself does not lower the risk of an existing portfolio of other investments,
as is the case with options, futures and CFDs, PPNs do provide advisors with a security that offers unique risk and
reward characteristics that may be suitable for certain investors, particularly those with a very low risk tolerance.

7
As of September 2011, CFDs are marketed and sold by IIROC-regulated firms to retail investors in British Columbia, Ontario and Quebec, and
to accredited investors only in the rest of Canada.

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PPN BASICS
A principal-protected note (PPN) is a debt instrument issued by a bank in the form of a deposit note. Like other
debt instruments, a PPN delivers a return (if any) in the form of interest and has a maturity date upon which the
issuer promises to return to holders of the PPN the face value or principal of the note. In the case of a PPN, however,
the interest rate is tied to the performance of an underlying asset, such as a portfolio of stocks, an index or one
or more mutual funds or ETFs. PPNs guarantee only the return of principal at maturity. Although PPNs are issued
by banks, they are not insured by the Canada Deposit Insurance Corporation (CDIC). PPN regulations in Canada
reflect their structure as bank deposit notes, and as a result PPNs are not considered securities and are not issued
via prospectus. Banks produce information statements that describe the key features and risks of the PPN, and PPNs
are subject to the PPN Regulations under the Bank Act.
The term to maturity of a PPN varies according to the issue, typically ranging from three to eight years, although
issues with shorter or longer terms are occasionally issued.

SUITABILITY OF PPNs
PPNs are generally most suitable for the extremely risk-averse investor who has the ability to take equity-like risk
but not the willingness to do so. In this case, as long as the advisor and investor are convinced that the issuer’s
guarantee is secure – and with the Big Six Banks in Canada being the primary issuers there should be little doubt
about this – investing in a PPN can provide the investor with exposure to equities without the risk of investing
in them directly, which in turn should give the investor the opportunity to earn a return required to meet their
financial goals.
In terms of figuring out how much of an investor’s portfolio to dedicate to PPNs, the answer, as with any
investments, is never 100%, and for many investors the correct answer is probably 0%. On the assumption,
however, that PPNs make sense for the risk-averse investor described above, the advisor should place PPNs on the
equity end of the investment spectrum and may recommend up to 20% of the investor’s equity allocation to PPNs.
As in any discussion of suitability, the advisor must consider all the needs and circumstances of an individual client
before recommending PPNs.

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SUMMARY
By the end of this chapter, you will be able to:
1. Explain how various risks can affect investment portfolios.
• Total risk can be separated into systematic risk and unsystematic risk.
• Systematic risk (or market risk): refers to the portion of a security or portfolio’s total risk that is related to
fluctuations in the return on the overall market.
• Unsystematic risk: refers to the portion of a security or portfolio’s total risk that is not related to fluctuations
in the overall market.
• The following four are some of the most common risks faced by investors and clients today:
« Inflation or purchasing power risk: inflation risk arises because of changes in the purchasing power of a
currency over time.
« Credit risk: credit risk is the risk of loss from deterioration in the credit quality of issuers and securities.
« Liquidity risk: liquidity risk concerns the ease with which an investment can be sold at or near a price equal
to its true value.
« Currency risk: the risk of loss from adverse movements in the value of a foreign currency in terms of the
Canadian dollar.

2. Evaluate portfolio investment risk.

• Historical risk (or realized risk) measures describe the actual risk experienced by an investment in a past time
period. An investment’s expected risk, on the other hand, is an individual’s or firm’s estimate of what the
investment’s risk will be over some future time period.
• Popular measures of investment risk:
« The standard deviation of returns, or just standard deviation, measures the extent to which investment
returns differ from the average return (in the case of historical standard deviation) or expected return
(in the case of expected standard deviation). Standard deviation measures the total risk of a security or
portfolio.
« Beta is a measure of the systematic risk of an investment. Beta is a measure of the relative risk of a security
compared to the risk of the overall market, which is usually taken to be a broad market index of securities.
« To measure downside risk, a risk measure such as the semi-deviation, which is similar to the standard
deviation except that only returns below the average return are included in the calculation and in the
probability of loss.

3. Recommend and justify a diversification strategy that reduces investment portfolio risk.
• The risk of a portfolio of securities depends not only on the risk of the individual securities, but also on the
correlation coefficient of each pair of securities’ returns.
• Diversification benefits result when securities that are less than perfectly positively correlated are combined
in a portfolio.
• A set of efficient portfolios is called the efficient frontier. Most efficient frontiers are built using the return and
risk of asset classes rather than of individual securities.
• When a client is investing in individual securities or funds, it is important that she diversify across the entire
asset class.

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 CHAPTER 15 | MANAGING YOUR CLIENT’S INVESTMENT RISK 15 • 31

4. Explain how option strategies can reduce investment portfolio risk.

• A protective put consists of a long position in an underlying asset and a long put option on the underlying
asset. The long put gives its holder the right to sell the underlying asset at a fixed price on or before the
expiration date. The protective put can be established for an individual stock or for a stock portfolio.
• Writing call options to hedge a stock that is expected to fall is an alternative to purchasing puts. However,
it is a more aggressive and sophisticated hedging strategy than protective puts, and requires more attentive
monitoring, especially when the price of the underlying stock starts to rise.
• Collars are used by investors who want to reduce the downside risk of an equity position, and who, in order to
obtain this protection, are willing to forgo some of the stock’s upside potential.

5. Explain how futures and contracts for difference (CFDs) can reduce investment portfolio risk.
• Future contracts: The proliferation of stock index futures contracts has allowed investors to eliminate the
systematic risk of a stock portfolio. Determination of the number of contracts to use in a hedge must take
into account the beta.
• Contracts for difference (CFDs): If investors want to eliminate all the risk of a long stock position, they merely
have to sell the same number of CFDs.

6. Recommend investments with built-in risk reduction features in appropriate circumstances.

• Principal protected notes (PPNs) have built-in risk reduction features. PPNs are generally most suitable for the
extremely risk-averse investor who has the ability to take equity-like risk but not the willingness to do so.

© CANADIAN SECURITIES INSTITUTE (2017)

 SECTION 9

IMPEDIMENTS TO WEALTH
ACCUMULATION

16 Impediments to Wealth Accumulation

© CANADIAN SECURITIES INSTITUTE (2017)

 Impediments to Wealth
Accumulation 16

CONTENT AREAS

What Are the Burdens of Wealth Accumulation?

What Are Tax Minimizing Portfolio Management Strategies?

What Are Tax-Efficient Investments?

What Are Inflation Sensitive Assets?

What Are Cost-Efficient Investments?

LEARNING OBJECTIVES

1 | Demonstrate the effect of inflation on wealth assets.

2 | Explain how different investments are taxed.

3 | Recommend appropriate tax-advantaged solutions and strategies.

4 | Recommend liquidation of investments that generate capital losses to offset gains.

5 | Recommend strategies to minimize and control the timing of taxes.

6 | Describe tax efficient investment options.

7 | Analyze the tax efficiency of investments within a wealth accumulation plan.

8 | Identify assets that retain their purchasing power.

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 3

INTRODUCTION
The process of wealth accumulation in and of itself is a difficult and time-consuming task. Creating an asset
allocation, selecting securities or setting a financial plan are but some of the tasks needed. Even if an advisor or
accumulator were to accomplish all these tasks correctly, the wealth accumulated can still be eroded by taxes,
inflation and transaction costs. These are factors frequently underestimated at the start of a wealth plan. In this
chapter, you will learn about these impediments to wealth accumulation and the strategies and investments to
protect assets from their effects.

WHAT ARE THE BURDENS OF WEALTH ACCUMULATION?

Maintaining and growing wealth can be as difficult as acquiring it in the first place. Obstacles such as taxes,
transaction costs and inflation easily erode hard-earned gains. Figure 16.1 charts the wealth of five investors, each
starting with $1,000, over the course of 30 years. Every year, each investor earns a nominal 6% interest and pays
33% income tax.

Figure 16.1 | Effect of Taxes, Inflation and Expenses on Wealth

6,000
5,000
Market Value

4,000
3,000
2,000
1,000
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
End of Year

Legend:

Each investor faces a different burden:

• Investor A: No inflation, no management expense ratio (MER), income tax paid at year 30
• Investor B: No inflation, no MER, income tax applied every year
• Investor C: 2% inflation every year, no MER, income tax paid at year 30
• Investor D: 2% inflation every year, no MER, income tax applied every year
• Investor E: 2% inflation every year, income tax and 2% MER applied every year.

The chart highlights the importance of compounding returns free of impediments. Investor A, carrying no burdens
until year 30, earns the largest terminal wealth at $3,848, while unlucky Investor E, burdened by all three
impediments each year, ends up with less than half of that ($1,221). Unfortunately, Investor E best represents the
average investor. Although the effect of taxes, transaction costs and inflation are practically inescapable, fortunately
there are strategies and tax-efficient investments that can minimize their consequences.

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16 • 4 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 9

TAXES
Of the three burdens – taxes, MERs and inflation – taxes represent the biggest impediment to wealth accumulation.
Taxation of investment earnings varies depending on the type of earnings and the investor’s province of residence,
but generally, there are four types of taxable investment income: interest, dividends, capital gains and return of
capital. All but return of capital represents an actual investment return.
Table 16.1 classifies interest, dividends, and capital gains under the types of income associated with various
investment products.

Table 16.1 | Taxation of Investments

Fixed Mutual Real

Type of Income Equity Income Futures Options Funds Estate
Capital Gain/Loss Yes Yes Yes Yes Yes Yes
Dividends Yes No No No Yes No
Interest or Ordinary income Yes Yes Yes Yes Yes Yes

INTEREST
The Income Tax Act does not strictly define interest income, but the Canada Revenue Agency (CRA) does refer to
interest as “the return or consideration or compensation for the use or retention by one person of a sum of money,
belonging to, in a colloquial sense, or owed to, another.” Interest income may arise from investments in bank
accounts, money market or fixed-income instruments such as corporate bonds, commercial paper, government
bonds, mortgage-backed securities or mutual funds. Of all types of income, interest income is taxed most
unfavourably. At the highest combined federal and provincial marginal tax rate, interest can be taxed at a rate as
high as 50%.

DIVIDENDS
Dividends are described by the CRA as “any distribution by a corporation of its income or capital gains made pro
rata among its shareholders”. A corporation in this case may be a public or private entity and shareholders include
those holding preferred or common shares.
The availability of a tax credit makes the taxation of dividend income from Canadian corporations more favourable
than the taxation of simple interest. Investors include in their taxable incomes the actual amount of dividends
earned plus a “gross up”. A federal tax credit can then be claimed against federal taxes on the grossed up amount.
Each province employs a similar mechanism to offset provincial taxes. As a result of the tax credit, the effective tax
rate on eligible Canadian dividend income is less than the rate for ordinary income. For 2017, the gross up factor will
be 38% and the federal tax credit will be 15.02% of the grossed up amount.
Foreign dividends have no similar tax credit and are taxed as regular income.

CAPITAL GAINS
Capital gains (or losses) arise from the sale or disposition of capital property. Although capital gains are usually
associated with the ownership of public or private businesses, capital gains may also arise from:
• exchanging one property for another;
• giving property (other than cash) as a gift;
• settling or cancelling a debt;
• transferring certain property to a trust;

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 5

• having property expropriated;

• theft of property;
• destruction of property;
• expiry of an option to buy or sell property.

EXAMPLE
A capital gain is created when an art collector sells a painting for twice the amount she paid for it.

Situations do exist, however, in which earnings from capital property are classified as income rather than capital
gains. For example, profits or losses from the short sale of stocks are considered income because there is no
intention of benefit from outright ownership. Gains and losses on stock trading might be included as business
income if the basis of the business was trading stocks.
Capital gains are taxed the most favourably of all earnings types. Only half of any capital gains realized in a given
year are included in income for tax purposes. Thus, the effective capital gains tax rate is half that of the ordinary
income rate.

RETURN OF CAPITAL
Occasionally, some mutual funds and real estate investment trusts make distributions in excess of the taxable
income investors receive from the fund or trust. The excess is known as a return of capital. Payouts can sometimes
exceed reported income because of large non-cash deductions, such as loss carry-forwards, depreciation, or
exploration and development allowances. Sometimes the payout represents the return of an investor’s capital.
A return of capital distribution is not taxable in the year the investor receives it. Instead, the original cost of
the units is reduced by the amount of the distribution and a new average cost per unit, known as the adjusted
cost base (ACB), is calculated. The ACB is the figure used to calculate the capital gain or loss when the units are
eventually sold.

INFLATION
While the timing and amount of taxes paid can be controlled to some extent, inflation is pervasive. If people wish
to maintain their current standard of living, there is little one can do to directly stop inflation. Over long periods of
time, inflation can seriously erode the nominal value of cash.
To maintain the purchasing power of wealth into the long term, an investor must seek assets that make positive net
returns after inflation and taxes.
For investors, the lesson is that stocks will perform poorly during times of high inflation but should make up for
those negative returns during periods of low or moderate inflation.
Bond returns, as measured by government securities, show decade-long periods of purchasing power gain and loss.
For investors with particularly long time horizons, bonds represent only a fair vehicle for maintaining purchasing
power. For investors with shorter horizons, bonds may or may not maintain their real value, depending on the
inflation prevailing at the time.
Cash does not maintain its real value over time. Treasury bills have generated returns slightly above inflation on a
pre-tax basis but, in a taxable account, will always return less than inflation after taxes because interest is taxed at
ordinary income rates.

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16 • 6 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 9

TRANSACTION COSTS
Transaction costs are any fees, explicit or implicit, which an investor pays to complete an acquisition or disposition
of a security. These fees can include visible costs such as mutual fund management fees or trailer fees. Transaction
costs can also be invisible such as wide bid/ask spreads or market illiquidity.

EXAMPLE
Stock A might be quoted at 200 shares bid at $10.00/300 shares ask at $10.50. Another stock B might be quoted
at 2000 shares bid at $10.00/2200 shares ask at $10.05. If an investor wants to sell 2000 shares of either stock,
he might get $10.00/share for stock B but somewhere less than $10.00 a share for stock A. Because there are not
enough bidders to absorb all 2000 shares of stock A, the bid price must go down.

There are two characteristics that distinguish transaction costs from taxes and inflation. Unlike with inflation and
taxes, transaction costs are one element, fortunately, over which investors have some control in terms of timing and
amount.

EXAMPLE
An investor could choose to sell a mutual fund after the window for deferred sales charges passes or could avoid
selling a stock during the time of day when liquidity is the lowest.

Unfortunately transaction costs are incurred whether or not an investor makes a return on the investment.

WHAT ARE TAX MINIMIZING PORTFOLIO MANAGEMENT

STRATEGIES?
All investors should be aware of the tax consequences of each security they buy or sell. Table 16.2 further illustrates
the difficulties in overcoming the hurdles created by taxes.
The aim of tax-aware investors is to minimize the amount, and control the timing, of taxes realized. Investors can
achieve this goal using a combination of the following techniques:
• incorporating tax implications into each trade
• harvesting tax losses
• crystallization (managing unrealized gains)
• selling most expensive securities first
• reducing the yield of securities
• reducing securities turnover
• purchasing a put option.

INCORPORATING TAX IMPLICATIONS INTO EACH TRADE

Investors should determine the effect on income tax of every potential sale. Doing so is a cost/benefit analysis
weighing the amount of taxes paid against the amount of gain from the new security. First, estimate the capital
gains tax likely to be realized. Next, reduce the proceeds of the sale by the size of the tax impact. Then estimate the
growth rates of both the new security and the one already held. The projected return of the new security is then
recalculated with the net tax profits. At some moment in the future the two projected return streams cross at a
break-even point. If the projected return of the new security exceeds the projected return of the security already
held within a certain timeframe, the trade is completed.

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 7

The timeframe is usually determined by calculating the average holding period, the inverse of the turnover rate. For
example, if a portfolio’s historical turnover is 50%, the average holding period is two years. If a break-even point is
calculated at three years, the trade is not considered. Table 16.2 provides an example.

Table 16.2 | Sample Trade for Tax Implication Calculations

Current Estimated Growth Rate Effective Capital Effective

Cost Share Price (including dividends) Gains Tax Rate Tax Rate
Medium Bank $30 $45 11% 20% 25%
ABC Corp. – $65 15% 20% 25%

An investor is considering replacing 5,000 Medium Bank shares with ABC Corp. shares. The portfolio’s turnover is
80%. At current prices, the investor would realize capital gains tax of $15,000:
$45 – $30 × 5,000 × 0.20

This leaves net proceeds of $210,000 to invest in ABC Corp.:

5,000 × $45 – $15,000

Compare the projected returns over the next few years of Medium Bank and ABC Corp.

Figure 16.2 | Breakeven Analysis Example for Medium Bank and ABC Corp.

$500,000

$450,000
Market Value

$400,000

$350,000

$300,000

$250,000
Legend:
$200,000 Medium Bank
0 1 2 3 4 5 6 ABC Corp.
Years from Present

At the estimated growth rates it would take ABC Corp. about two years to exceed the value of the Medium Bank
position. The portfolio’s turnover is 80%, which implies a holding period of 15 months1. Therefore, the investor
should retain Medium Bank in the portfolio rather than create excessive turnover.
This methodology provides a framework for incorporating tax costs into investment planning. Tax costs are, in
essence, transaction costs just as much as commissions are and they must be recovered before the next trade is
considered.

1
1 divided by 0.80 equals 1.25 years. To convert this to months, we multiply 1.25 by 12 to arrive at 15 months.

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16 • 8 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 9

TAX-LOSS HARVESTING
Securities trading well below cost have unrealized capital losses valuable to the investor. Tax-loss harvesting
is the act of voluntarily taking losses for the purpose of creating a current tax deduction to offset realized gains.
The purpose is to minimize tax liabilities and keep the asset in the portfolio, where it can benefit the most from
compounding.
Poorly performing securities not expected to recover in the near to medium term are candidates for harvesting.
Securities that are trading well above cost or are realizing gains – and that the investor expects to hold for a short
time – can be sold to provide the offsetting capital gain.
The investor may want to stay in that asset class or industry after executing the loss trades. To do so, the investor
can purchase a substitute security with a high correlation to the original. A high-correlation security is one from the
same sector or industry, with a similar beta or influenced by the same economic factors.
Part of the value of tax-loss harvesting derives from reinvesting the tax savings in the substitute security. For every
$100 in losses an investor realizes, $100 times the capital gains rate in tax savings is generated. The idea is to use
another security to compound the tax savings at a more favourable return.

EXAMPLE
Assume an investor buys Big Bank stock at $100. One year later, the stock has fallen to $80. The investor sells
the stock for a loss of $20 and uses the $20 to offset capital gains elsewhere in the portfolio. At a capital gains
rate of 20%, the investor would save $4 in taxes that otherwise would have been paid. With the $80 proceeds,
the investor could reinvest $84 in JAB Bank (the substitute) or wait more than 30 days to buy Big Bank again. At
$84, this would become the new cost basis for taxes. The investor would have 5% more purchasing power as a
result of the tax savings ($4/$80). If the repurchased securities appreciated, any gains would help recover some
or all of the $16 reduction in cost basis.

Four issues are very important when making tax-harvesting trades:

1. Limitations imposed by the CRA
2. Portfolio risk and return profile could change
3. Transaction cost may be prohibitive
4. Portfolio losses may be too great.

CRA imposes limitations on tax-loss harvesting trades through its superficial loss rules: investors cannot buy the
same security within 30 days before or after the loss trade. In addition, the capital loss may be applied only to the
cost base of the original security. The new security should be different enough to satisfy the tax authorities yet
similar enough to be a good substitute in the portfolio.
Be aware that the portfolio’s risk and return profile could change during the tax-harvesting process. Investors may
take on unwanted sector exposure if they are forced to wait the 30-day superficial loss period or if they cannot find
good substitute securities. The risks to the portfolio must be judged against the benefits of the tax losses.
Transaction costs might be prohibitive relative to the benefits of the loss harvesting. Transaction costs not only
include the brokerage commissions but also the effect on the bid/ask spread from the buy/sell orders. This becomes
a significant cost as the capitalization size of the portfolio becomes smaller. The value of the tax deduction must
meaningfully exceed the transaction costs before tax harvesting should occur.
Finally, loss harvesting should be delayed if losses in a portfolio are accumulating, which is common during periods
of sustained declines. Tax-loss harvesting loses its benefit if it is not applied right away.

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 9

CRYSTALLIZATION
Crystallization, or managing unrealized gains, is similar to tax-loss harvesting but takes the process one step
further. After the offset trades are executed, more of the security in the gain position is purchased. This gaining
security should be the portfolio holding with the largest unrealized gain and/or have the shortest expected holding
period. The effect of the purchase is to increase the cost basis of the remaining lots. The unrealized gain is reduced
and the future tax liability is lowered. Superficial loss rules do not apply here because the security repurchased was
originally sold for a gain.
For instance, assume an investor holds DEF Bank and JKL Energy in his portfolio and purchased the stocks during one
year in lots as shown in Table 16.3.

Table 16.3 | Crystallization – Sample Holdings

DEF Bank JKL Energy

Lot Shares Cost per Share Cost Shares Cost per Share Cost
1 100 $45.50 $4,550 200 $32 $6,400
2 100 $47.00 $4,700 – – –
3 400 $49.00 $19,600 – – –
4 400 $51.00 $20,400 – – –
Total 1000 $49.25 $49,250 200 $32 $6,400
average average

DEF Bank’s current share price is $53, while JKL Energy’s current price is $28. The investor is holding an unrealized
loss in JKL Energy of $800:
200 × ($32 – $28)
and an unrealized gain in DEF Bank of $3,750
1,000 × ($53 – $49.25)
The investor wishes to use the capital loss in JKL Energy to offset some of the gains in DEF Bank, but he wants to
maintain his share exposure. By employing crystallization, the investor will achieve these goals. The number of DEF
Bank shares the investor should sell to offset the capital loss is equal to the total capital loss in JKL Energy divided by
the capital gain per share in DEF Bank:
$800 / ($53 – $49.25) = 213
To maintain the share exposure to DEF Bank, the investor will buy back 213 shares of DEF Bank at $53 each.

Table 16.4 | Crystallization – DEF Bank Holdings

Shares Remaining Cost/Av Cost per Share Cost

Before crystallization 1,000 $49.25 $49,250.00
After 213 DEF Bank shares sold 787 $49.25 $38,759.75
New lot purchased 213 $53.00 $11,289.00
After crystallization 1,000 $50.05 $50,048.75

The investor will again hold 1,000 DEF Bank shares but at a higher per share cost ($50.05 versus $49.25). This
reduces future tax liability when the shares are sold.

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16 • 10 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 9

SELLING MOST EXPENSIVE SECURITIES FIRST

To reduce tax liability, an investor can sell the securities with the highest cost basis first if the asset resides in two or
more taxable portfolios and a portion of the position must be sold.
To illustrate, suppose an investor buys 30 shares of an equity mutual fund for her taxable account (portfolio 1). Late
in the year her husband buys 30 shares of the same mutual fund for his taxable account (portfolio 2). The effective
capital gains tax is 20% and the couple is forced to sell 30 shares in December at $100 per share.

Table 16.5 | Capital Gains Tax Due for Portfolio 1

Shares Purchase Price Portfolio 1

Shares sold 30
Current price $100.00
Proceeds $3,000.00
Cost 10.71 $93.36 $1,000.00
10.92 $91.59 $1,000.00
8.37 $90.02 $753.52
Cost of 30 shares $2,753.52
Gain $246.48
Tax due $49.30

Table 16.6 | Capital Gains Tax Due for Portfolio 2

Shares Purchase Price Portfolio 2

Shares sold 30
Current price $100.00
Proceeds $3,000.00
Cost 30 $85.40 $2,562.06
Cost of 30 shares $2,562.06
Gain $437.94
Tax due $87.59

The 30 shares in portfolio 1 should be sold first because they are the higher cost basis shares. Less tax is due for
portfolio 1 ($49.30) than for portfolio 2 ($87.59).
The technique of selling the most expensive securities first is useful only when the same investment resides in two
or more taxable accounts owned by different people, such as by the two spouses in the example above. If the asset
resides in a single account, the investor has to use the adjusted cost basis of the entire position to calculate gains
and losses. Further, if the two accounts are owned by the same person, the weighted average cost rules will require
the positions in the two accounts be calculated together to arrive at one weighted average cost for the specific
security and therefore this strategy would not be applicable.

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 11

REDUCING YIELD AND TURNOVER

Reducing the yield in a taxable portfolio will minimize the amount of less tax-friendly interest and dividend income.
Tax paid today decreases the market value of the portfolio and dampens the effect of compounding returns.
Decreasing the yield may tilt the risk of the portfolio toward the growth style of investment more than an investor
desires. If so, the investor can maintain his overall style diversification by, for example, buying higher-yield, more
value-oriented stocks for a separate non-taxable account. Reducing the yield may also be achieved by, for similar
bonds, replacing higher-coupon bonds with bonds trading at a discount to par. The investor replaces the higher-
percentage coupons with lower-percentage coupons and also realizes capital gains on the lower-coupon bond that
is bought at a discount and matures at par.
Reducing the turnover (the number of shares traded in a period of time as a percentage of the total shares in a
portfolio) does not imply keeping turnover at low index-like levels. Some turnover is necessary to book losses to
offset realized capital gains. Reducing the turnover means reducing excessive trading. Higher turnover increases
the chance for capital losses and reduces the after-tax return of the portfolio, especially over long periods. High
turnover also increases brokerage fees, further eroding the value of the taxable portfolio.

PURCHASING A PUT OPTION

Purchasing a put option on an individual stock or index places a floor on the value of the security. This is valuable
to an investor who needs to liquidate a position but may not want to do so until a year in which her tax position is
more favourable. The put gives the investor time and protection for the cost of the contract. For example, assume
the owner of 1,000 DEF Bank shares had bought the stock at a cost of $30 per share. The price in early October is
$50. The holder believes the stock will fall to $40 in the near term but does not want to sell until next year, when
she is in a more beneficial tax position. The DEF Bank six-month $50 put option premium is $3.50.
For every $10 per share change in DEF Bank on the unhedged position, the market value of the client’s position
changes $10,000 in the same direction. At option expiration, for every $10 per share change in the hedged position,
the put exactly offsets the loss in the stock. The cost to the investor is $3,500 (1,000 shares multiplied by $3.50).
At expiration, if the stock price has declined, the investor can exercise the put option, liquidate the entire stock
position, and be guaranteed a profit of $16,500 on the stock position regardless of the stock price.
When constructing a long-stock, long-put strategy it is important not to pay too much in premium for the option.
In this example, the DEF Bank put option was 17.5% of the unrealized profit. Therefore, the investor should select a
put strike price as close to the current market price as possible.

Table 16.7 | Protective Put Strategy

Stock Price at Expiration $10 $20 $30 $40 $50 $60 $70

Unhedged profit/loss ($20,000) ($10,000) $0 $10,000 $20,000 $30,000 $40,000

of stock only position

Cost of the put option ($3,500) ($3,500) ($3,500) ($3,500) ($3,500) ($3,500) ($3,500)

In-the-money amount $40,000 $30,000 $20,000 $10,000 $0 $0 $0

of the put option

Hedged profit/loss of stock $16,500 $16,500 $16,500 $16,500 $16,500 $26,500 $36,500
and put option positions

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16 • 12 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 9

WHAT ARE TAX-EFFICIENT INVESTMENTS?

Tax efficiency measures how much of a pre-tax return an investor keeps after paying tax liabilities on realized or
unrealized gains. There are three commonly used measures or efficiency ratios:
Capture Ratio
RAT/RBT (16.1)

Relative Wealth Measure

< RAT  RBT > <1 RBT > q 1,000 (16.2)

Morningstar Tax-Cost Ratio

1  <1 RAT > <1 RBT > q 100 (16.3)

where:
RAT = return after tax
RBT = return before tax

To demonstrate the three efficiency ratios, assume six portfolios have the before- and after-tax return profiles
shown in Table 16.8.

Table 16.8 | Efficiency Ratios – Sample Returns

Before-Tax After-Tax Relative Wealth

Portfolio Return Return Capture Ratio Measure Morningstar
1 10% 9% 90% ($9.09) 0.91
2 (1%) 1% (100%) $20.20 (2.02)
3 (8%) (6%) 75% $21.74 (2.17)
4 (10%) (11%) 110% ($11.11) 1.11
5 8% 10% 125% $18.52 (1.85)
6 (10%) (8%) 80% $22.22 (2.22)

The capture ratio is simply the relative proportions of after-tax and pre-tax returns. If portfolio 1 returned 10%
before taxes and 9% after taxes, its capture ratio is said to be 90%. Higher positive numbers supposedly equal
better tax efficiency. Unfortunately, the ratio makes less sense when returns are negative or tiny, or if after-tax
returns are higher than pre-tax returns. With a 110% capture ratio, portfolio 4 cannot be more tax efficient than
portfolio 1, even though both lost 100 basis points of return to tax.
The Relative Wealth Measure (RWM) was developed by CFA Institute in response to the weakness of the capture
ratio. The RWM measures the amount per $1,000 of assets that needs to be invested at the pre-tax return to pay
the tax liability. The RWM is not affected by the direction or magnitude of portfolio returns. Tax efficiency under
the RWM implies the portfolio is generating net tax savings and is denoted with a positive number; the greater the
positive number, the more tax efficient the portfolio. Tax inefficiency indicates the portfolio is paying proportionally
more taxes and is denoted with a negative number; the larger the negative number, the more inefficient the
portfolio. For example, portfolio 4 is less tax efficient than portfolio 1 because portfolio 4 required more pre-tax
dollars ($11.11 versus $9.09) to generate the cash needed to pay the eventual tax liability.

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The Morningstar tax-cost ratio is a variation of the RWM. It was developed to determine the percentage of assets
lost to tax after distributions. A positive figure indicates that the portfolio paid tax and a negative number means
the portfolio saved tax. The ratio can vary from zero for funds that have not made any distributions to more than
5% for funds that have issued significant distributions.
A solution to the burdens of wealth accumulation is to buy tax-efficient investments. Tax efficiency is characterized
by low turnover, few distributions and distributions made as capital gains. Low turnover and low distributions are
features of exchange-traded funds (ETFs), index funds and a select few mutual funds.

EXCHANGE-TRADED FUNDS
In Canada, exchange-traded funds (ETFs) are legally organized as mutual fund trusts. The units of the trust are
listed and traded on stock exchanges, similar to individual stocks. The ETF holds an underlying basket of securities
(equities, bonds, commodities or derivatives), which tends to follow a preset list of securities. The S&P/TSX
Composite Index is an example of a preset list that ETFs follow.
This list is established and maintained by preset rules that set the criteria for the securities in this index. ETFs that
follow this approach are called “passive” investments. These types of ETFs represent the significant majority of ETFs
listed.
The value of an ETF reflects the net asset value of the underlying securities and trades based on the weighted-
average bid and ask spread of the portfolio. Like stocks, ETFs can be bought on margin and sold short and some
have options trading on them. Income generated by the securities in the ETF, such as dividends, interest or capital
gains, flows through to the investor so that it maintains its original characteristics.
With standard ETFs, the reference index can be either exactly replicated (“full replication”) or approximately
constructed (a process known as “sampling”).
Full replication is often used with equity portfolios of large capitalization stocks. In this case, the ETF holds all of the
stocks in the same weight as the respective index. As all the stocks are held in the same weight as the index, a full
replication process will track extremely close to the benchmark index (resulting in limited tracking error).
Sampling is the process where the portfolio manager selects securities and their weighting to best match the
performance of the index. While sampling is often used for fixed income, there are some cases where a full
replication is not optimal for equity ETFs. These cases reflect either considerations of liquidity or index construction.
With index construction, if the number of holdings within the index is significantly high a sampling approach would
make the ETF more efficient given the costs to reproduce the full index. With a sampling approach there could be
some differences between the index and the performance of the ETF. In most cases, this tracking error is small but
should be reviewed on a regular basis.

INDEX FUNDS
Index funds are passively held investments that track the composition and return of a target index. An index fund
can replicate the target index by buying all or most of the securities underlying it. Index funds are far more tax
efficient than the average actively managed fund. Index fund turnover typically results from the target index merely
reconstituting its members through attrition or mergers.
But not all indexes are similar and not all index funds are equal in their tax efficiency. As an index holds a greater
proportion of mid- and smaller capitalization stocks, turnover increases as stocks are graduated, demoted and
acquired. For instance, tax efficiency in an S&P 400 Mid-Cap Index fund would be lower than that of a similarly
managed S&P 500 Index fund.
Much also depends on the construction rules of the particular index. Some have particularly high turnover. The Dow
30 and S&P/TSX Composite historically have low turnover but the S&P 500 Value and Growth Indexes can average
well over 10% turnover.

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Furthermore, not all index funds are pure index funds. Many portfolios are a core index fund with an actively
managed portion. For example, a fund might invest its assets in the futures and options of an underlying U.S. index.
In addition, the fund may also make active bets on the Canadian dollar using futures and options and can carry a
cash position of up to 4%.

ACTIVE MUTUAL FUNDS

If tax efficiency is defined as accruing returns by capital gains versus regular income, then equity mutual funds
are more tax efficient than bond mutual funds. If the definition is expanded to include low turnover, the numbers
narrow further. Active equity mutual funds characterized by low turnover are the domains of the value manager.
If the definition is expanded further to include low distributions, one needs to find mutual funds with built-in tax
losses. Generally, active mutual funds intentionally managed with an eye to tax efficiency are in the minority.

TAX-SHELTERED INVESTMENTS
A tax-sheltered investment is any investment that shelters or reduces income tax. A tax shelter can be as simple and
legal as an RRSP or as complicated and sometimes legally dubious as some limited partnerships.

TAX CREDITS FOR FLOW-THROUGH SHARES

Flow-through shares are a type of common equity issued by junior resource companies. The sale of flow-through
shares allows exploration companies, which typically show accounting losses because they do not have the
profitability to offset exploration costs, to raise capital from investors. In return, the resource companies renounce
certain deductible expenses incurred in the running of their businesses. These deductions are flowed through to
investors, though the costs must meet particular qualifications for investors to claim them.
The exploration company must have made the expenditures, known as Canadian exploration expenses (CEEs), within
Canada and in non-development processes such as prospecting, sampling, surveying and drilling. Qualified CEEs
are accumulated in a pool and are 100% available for deduction in the year they are incurred. Certain costs known
as Canadian development expenses (CDEs) are also available for deduction. CDEs are funds spent on drilling and
completing oil wells or sinking or excavating mine shafts. A company’s CDEs are accumulated in a pool and tax-
paying investors can use up to 30% in unclaimed balances in any one year.
Someone who invests in flow-through shares will be able to claim as a deduction all of the upfront cost of the
shares in the year of the purchase. The taxpayer also has the option of carrying back the deductions three years or
carrying them forward seven years. On disposition, the flow-through shares carry an adjusted cost base of zero.
Therefore, any positive value of the share position will be considered capital gains.
There is another 15% federal government tax credit available for qualified companies that undertake exploration
for new developments within Canada. This applies only to mining activities and not to the extraction of oil or gas.
Flow-through shares that carry the extra 15% federal tax credit are called super flow-through shares. The federal tax
credit can be carried back three years or forward 20 years and is non-refundable (the investor must pay taxes to use
the claim).
The window of opportunity to issue super flow-through shares is limited. Federal legislation was set to expire at
the end of 2005 but was extended to March 2007. Since then this federal tax credit has been extended 12 months
in each subsequent fiscal year’s budget up through 2017. The resource sector is lobbying for rolling three-year
extensions. Some provinces have added their own tax incentives. The provincial tax credit applies only if the investor
is a resident of that province and exploration occurs in the same province.
Given the difference in marginal provincial tax rates and the availability of provincial flow-through tax credits, the
benefits of flow-through shares to individual investors will vary depending on the investor’s place of residence. The
overall benefit of the federal and provincial tax credits is reduced because the CRA requires that investors claim the
tax credits as income the following year.

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RISKS OF FLOW-THROUGH SHARES

Although the tax breaks offered by flow-through shares are generous, they are that way for a reason: investors
must remember that these stocks are equity positions in junior resource companies, among the riskiest asset
classes available. Without tax credits, junior resource companies would be too risky to attract enough investment
to conduct any exploration activity. By providing tax credits, governments have in effect become silent partners,
subsidizing exploration costs and lowering the risk for the investing public.
The rules governing good equity analysis still apply. A potential purchaser of flow-through shares should first
evaluate the company on its investment merits alone. What is the quality of the management? Is the company well
capitalized? What are the chances that the company can strike a mineral deposit or oil field?
This last point requires specialized knowledge and investors who wish to add flow-through shares to their portfolios
may consider investing in flow-through limited partnerships. Flow-through limited partnerships hold a portfolio of
flow-through issuers and will often have geologists on staff to evaluate a company’s chances of striking a deposit.
Limited partnerships also have the advantage of the economies of scale. They can purchase flow-through shares
in private placements and avoid the liquidity problems a smaller investor would encounter if buying shares on the
open market.
Ultimately, if a firm offers a chance at growth, an investment in flow-through shares can produce excellent after-tax
returns, but if it cannot find any mineral deposits or oil fields, the investor may end up with an asset with no residual
value.

LIMITED PARTNERSHIP INVESTMENTS

Limited partnership investment tax shelters provide investors with a flow-through of expenses from a business for
tax deductions with limited exposure to legal liability. The investor can deduct the majority of the expenses in the
first year. The tax shelter does not provide for permanent tax savings, merely tax deferral. There may be a significant
tax bill when the investor sells the investment because tax deductions taken in the early years will reduce the
adjusted cost base. Any income produced by the investment in the interim will also be taxable.
In response to abuses in the past, the CRA has greatly tightened regulation of limited partnerships. At one time,
some limited partnerships provided greater deductions than the amount invested, but current rules prohibit
investors from writing off more than the amount originally invested (the at-risk amount). If assets or expenses have
been inflated, the inflated part of the losses will be disallowed. Deductions are also restricted if the purchase of the
limited partnership was financed with limited-recourse debt (LRD). In other words, if the loan was acquired without
bona fide intention to repay the principal along with interest, the CRA would prohibit the amount of the deduction
or reduce the cost of the investment by the amount of the LRD.
In addition, there are rules that require certain limited partnerships to prorate expenses (otherwise deductible in the
current year) over a longer term. If the ACB of the investor’s share in a limited partnership becomes negative, the
investor will have to report a capital gain equal to the negative amount. If no real business activity is carried on by a
limited partnership or is there is no reasonable expectation of profit, all losses claimed will be disallowed.
Investors should evaluate the potential value of any tax shelter as thoroughly they would any other investment.
According to the CRA, investors should be wary of the following situations when evaluating tax shelters:
• No real business activity is carried on.
• The business has no reasonable expectation of profit.
• The assets of the business are overvalued.
• The expenses are inflated.
• Losses for tax purposes exceed the amount at risk.
• Verbal assurances of income tax consequences from the promoter are different from, or are not confirmed by,
professional opinions contained in the investment documents.

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A few audited tax-shelter promoters and investors have claimed innocence based on a tax shelter’s advance income
tax ruling and registration under the Income Tax Act. An advance income tax ruling is a statement written by the
CRA indicating how the CRA will interpret and apply certain provisions of the Income Tax Act to a transaction a
taxpayer is contemplating. The CRA has indicated, however, that advanced rulings do not guarantee deductions. The
rulings will judge neither a business’s legitimacy and expectation of profit nor the fair market value of a property or
service. Rulings may not reflect current law or the current interpretation of law.
Tax shelter registration numbers are used for identification purposes only. They simply enable the CRA to identify all
tax shelters and their investors. The existence of a tax shelter number offers no guarantee that taxpayers will receive
the proposed tax benefits.

ALTERNATIVE MINIMUM TAX

Investors must be aware of the alternative minimum tax (AMT) when using tax shelters extensively. The AMT
is meant to ensure that taxpayers pay a minimum amount of tax even if significant portions of their incomes are
sheltered or reduced by certain deductions. The AMT is an alternative to a person’s regular income tax. The taxpayer
pays the higher of the two taxes.
The AMT is a concern when significant income is sheltered in any type of tax shelter. For example, if much income
is sheltered by losses incurred in a limited partnership investment or other tax shelter, the taxpayer may be subject
to AMT even though regular income was largely or wholly reduced by the tax shelter. When considering making a
tax-sheltered investment, the investor must be aware that the AMT may apply.
To compute the AMT, begin with the investor’s regular taxable income for the year. Certain deductions and
exemptions are added back. This results in adjusted taxable income for AMT purposes.
If the AMT exceeds the regular tax, the AMT is payable. If the AMT is less than the regular income tax, the regular
tax is paid. If the AMT is paid, the excess of the AMT over the regular tax amount can be carried forward as part of
the minimum tax carryover. This can be carried forward seven years to offset regular income tax in any one year to
the extent that regular tax exceeds the AMT for that year. This carry forward softens the blow of the AMT, in that
taxpayers get back some of the AMT if they claim fewer deductions or credits in future years.

WHAT ARE INFLATION SENSITIVE ASSETS?

REAL RETURN BONDS

Real return bonds (RRBs) are in some ways safer investments than are nominal bonds. The market price of an RRB
is affected only by changes in the real interest rate, while the market price of a nominal bond varies with changes
in the real interest rate and changes in inflation expectations. Furthermore, a nominal bond is exposed to forecast
error risk, the chance that actual inflation over the life of the bond will be higher than expectations embedded in
the yield.
For RRB investors, their real yield to maturity is certain because interest and principal are indexed to increases at the
actual inflation rate.
Given the RRB’s inflation protection, an investor simply saving for retirement should consider buying RRBs if he
expects actual inflation to be higher than the expectations embedded in nominal bonds.
Inflation expectations can be calculated by subtracting the yield to maturity (YTM) of the RRB from the YTM of
the nominal bond. A 30-year nominal bond with a 4.5% YTM has built-in inflationary expectations of 2.5% if the
30-year RRB is trading at a 2% YTM. If actual inflation over the 30-year life of this bond is zero and real interest
rates remain at 2%, the nominal-bond holder would earn 2.5% above the real rate. RRB investors would earn

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 17

merely the real rate of 2%. If actual inflation is 5%, the nominal-bond holder would lose substantial purchasing
power by the time the bond matures. RRB investors would maintain the real value of their coupons and principal.

MARKET PRICE RISKS OF RRBS

Market prices of real-return bonds can sometimes be more volatile than those of nominal bonds, depending
on how yields vary. The price of a nominal bond is affected by the real interest rate and the embedded inflation
expectations. The price of an RRB is affected only by changes in the real interest rate. A change in inflation
expectations will change the price of a nominal bond but not the price of an RRB. Changes to the real interest rate
affect both types but affect RRBs more. Coupon payments from an RRB are smaller than those from nominal bonds
with similar maturities. Thus RRBs display greater price sensitivity to changes in the real interest rate.
RRB price volatility has also resulted from the relative illiquidity of the market.

REAL ESTATE AS AN INFLATION HEDGE

Residential and commercial real estate has long been considered the asset to purchase to hedge against inflation.
Academic research has confirmed the positive relationship between inflation and real estate returns.
The drawback to real estate investing is that it can be much more time and capital intensive than investing in
financial assets. In addition, there can be significant carrying costs and annual maintenance costs that must
be borne to keep the property in good order. Investors can tailor the form of their exposure depending on the
amount of time and capital they can commit. Participation can be 100% equity ownership, joint venture or limited
partnership. Some real estate investment management companies organize pools with minimum commitments
starting at about $500,000. For a management fee, these firms research, maintain and manage a portfolio of
commercial properties.
The effectiveness of real estate investment trusts (REITs) as an inflation hedge is up for debate. At the core, REITs are
a financial asset the value of which is based on real estate. Like all other common stock, REITs will lose capital value
in times of inflation. To be certain of an effective hedge, the investor should own the property directly.

COMMODITIES AS AN INFLATION HEDGE

Commodities have long been considered an inflation hedge. Gorton and Rouwenhorst2 studied commodity futures
returns over a 46-year period. They found that commodities were negatively correlated with bond and stock returns
over most of that period. The negative correlation was strongest over longer holding periods and stemmed primarily
from commodities’ positive correlation with inflation in general and with unexpected inflation and changes in
expected inflation.
Ibbotson,3 in a study that included U.S. stocks, U.S. bonds, Treasury bills, Treasury Inflation-Protected Securities
(TIPS), international bonds and stocks over a 25-year period, found that commodities were positively correlated to
both the rate of inflation and changes to the rate of inflation. In fact, during the era of high inflation of the 1970s,
commodities far outperformed other assets classes.
To gain exposure to commodities, an investor must decide which commodities to invest in and the form the
investment will take.

2
K. Geert Rouwenhorst and Gary B. Gorton. “Facts and Fantasies about Commodity Futures.” Yale ICF Working Paper No. 04-20. February 28,
2005.
3
Ibbotson Associates. Strategic Asset Allocation and Commodities. Ibbotson Associates. March 2006.

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PRECIOUS METALS, INDUSTRIAL METALS OR ENERGY

A study by Normand (2006)4 of 36 years of returns in the United States, Europe and Japan found that energy and
precious metals most frequently had the highest positive correlation to inflation of all the asset classes. Another
study,5 based on 200 years of data, concluded that the relative price of gold is driven by and is the opposite of the
real return from capital markets. The real return moves opposite the direction of inflation, therefore, inflation has
been a prime mover of gold prices. Recent data bears this out.

WHICH VEHICLE?
Investors wishing to hedge their portfolios against inflation can do so using physical ownership of commodities,
derivatives or equities. Physical ownership may require large amounts of capital plus maintenance, insurance,
logistical and storage expenditures.
Derivatives (futures, futures options and forwards) require no direct carrying costs, but the leverage and mark-to-
market features may be too risky for most investors. Equity investment in commodity-based companies may be the
best vehicle through which to invest in commodities. Equities require no storage costs and are in most cases liquid
and less risky than derivatives. Participation in equity shares of a commodity-based company can be as simple as
direct ownership in the company or investment in products such as sector mutual funds or exchange-traded funds.

COLLECTIBLES AS AN INFLATION HEDGE

Collectible items (for example, fine art, wine and antiques) have been commonly accepted as an alternative
asset. Shortly after the stock market crash of 1987, a painting by Vincent van Gogh, Irises, sold for a then-record
US$53.9 million. The event heralded in a new bull market for art as investors, fearful of the stock market, poured
money into Picassos, van Goghs and Warhols.
Anyone who wants to purchase collectibles should ask himself if he is purchasing the item as an investor or as a
collector. As an investor, the individual should be prepared to deal with the risks. The market for collectibles is very
specialized because of the non-commoditized nature of the assets. Liquidity can be very thin. It may be very difficult
to quickly sell the item. Prices may plunge seemingly without reason. Collectibles pay no monetary dividends and
may require considerable sums for insurance, storage and maintenance. Assessing the price appreciation potential
of a collectible requires expert knowledge and experience, skills an investor may not have.
As a collector, an individual will enjoy the purchase more for its intrinsic value. Collectors will reap intangible
rewards knowing that they own something of scarcity, value or beauty. Collectors will likely own their assets longer
than investors will, giving themselves time for the market value of their pieces to appreciate above the rate of
inflation.
But not all collectibles are equal as inflation hedges. Many of the best inflation hedges are collectibles that trade at
the more expensive end of the market, such as classic cars, fine art and antiques. Investors who cannot afford the
higher prices of well-known collectible items must gravitate toward the less-known and more affordable markets,
where the payoffs are riskier.

4
John Normand. “Hedging Inflation with Real Assets.” Global Investor. April 1, 2006.
5
Lawrence H. Summers and Robert B. Barsky. “Gibson’s Paradox and the Gold Standard.” Journal of Political Economy vol. 96 (June 1988):
pp 528–550.

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 19

WHAT ARE COST-EFFICIENT INVESTMENTS?

Exchange-traded funds and many index funds are the most cost efficient investments available. Because ETFs and
index funds are passively managed, expense ratios are typically significantly less than 1.0%.
Not all index funds are constructed similarly, however. Costs for index funds can vary depending on how closely
the fund manager tracks the index (the tracking error). The target index may be perfectly tracked by buying all
the stocks that comprise the index, in the same proportions. But transactions costs increase with the purchase of
smaller-capitalization stocks, and index managers usually buy a subset of the stocks within the index that closely,
but not exactly, resembles the benchmark. A partial replication reduces the transaction costs but increases the
tracking error. The manager does more work to keep weights in line as market prices for the stocks change.
Many index funds include overlay strategies in an attempt to increase potential returns above the index. As a result,
several funds post MERs that equal or even surpass those of funds that are 100% actively managed.
Active mutual funds are on average more costly than ETFs and index funds but they can be very cost efficient in
terms of price for active management. An investor can switch fee-free among mutual fund classes within a mutual
fund corporation and many of the larger fund companies offer funds at a deferred sales charge.

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SUMMARY
By the end of this chapter, you will be able to:
1. Demonstrate the effect of inflation on wealth assets.
• Over long periods of time, inflation can seriously erode the nominal value of cash.
2. Explain how different investments are taxed.
• Interest income: does not have any tax advantages.
• Dividend income:
« Eligible Canadian source dividend income: a gross up and dividend tax credit provides a tax advantage to
investors.
« Foreign source dividends have no gross up, no similar tax credit and are taxed in the same way as interest
income.
• Capital gains: Only half of any capital gains realized in a given year are included in income for tax purposes.
• Return of capital: A return of capital distribution is not taxable in the year the investor receives it. Instead, the
original cost of the units is reduced by the amount of the distribution and a new average cost per unit, known
as the adjusted cost base (ACB), is calculated.

3. Recommend appropriate tax-advantaged solutions and strategies.

• Incorporating tax implications into each trade:
« Investors should determine the effect on income tax of every potential sale. Doing so is a cost/benefit
analysis weighing the amount of taxes paid against the amount of gain from the new security.

4. Recommend liquidation of investments that generate capital losses to offset gains.

• Tax-loss harvesting:
« is the act of voluntarily taking losses for the purpose of creating a current tax deduction to offset realized
gains. The purpose is to minimize tax liabilities and keep the asset in the portfolio, where it can benefit the
most from compounding.
• Crystallization:
« or managing unrealized gains, is similar to tax-loss harvesting but takes the process one step further. After
the offset trades are executed, more of the security in the gain position is purchased.
• Selling most expensive securities first:
« The technique of selling the most expensive securities first is useful only when the same investment resides
in two or more taxable accounts owned by different people, such as by the two spouses.

5. Recommend strategies to minimize and control the timing of taxes.

• Reducing yield and turnover:
« Reducing the yield in a taxable portfolio will minimize the amount of less-tax-friendly interest and dividend
income.
« Reducing the turnover means reducing excessive trading.
• Purchasing a put option:
« Purchasing a put option on an individual stock or index places a floor on the value of the security. This is
valuable to an investor who needs to liquidate a position but may not want to do so until a year in which
her tax position is more favourable.

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 CHAPTER 16 | IMPEDIMENTS TO WEALTH ACCUMULATION 16 • 21

6. Describe tax efficient investment options.

Tax efficiency is characterized by low turnover, few distributions and distributions made as capital gains. Low
turnover and low distributions are features of exchange-traded funds (ETFs), index funds and a select few
mutual funds.
• Exchange-traded funds: In Canada, exchange-traded funds (ETFs) are legally organized as mutual fund trusts.
The units of the trust are listed and traded on stock exchanges, similar to individual stocks.
• Index funds: Index funds are passively held investments that track the composition and return of a target
index.
• Mutual funds: Active equity mutual funds characterized by low turnover are the domains of the value
manager. If the definition is expanded further to include low distributions, one needs to find mutual funds
with built-in tax losses.

7. Analyze the tax efficiency of investments within a wealth accumulation plan.

Tax efficiency measures how much of a pre-tax return an investor keeps after paying tax liabilities on realized or
unrealized gains. There are three commonly used measures or efficiency ratios:
Capture Ratio
RAT/RBT

Relative Wealth Measure

< RAT  RBT > <1 RBT > q 1,000

Morningstar Tax-Cost Ratio

1  <1 RAT > <1 RBT > q 100

where:
RAT = return after tax
RBT = return before tax

8. Identify assets that retain their purchasing power.

• Real return bonds: for real return bond investors, their real yield to maturity is certain because interest and
principal are indexed to increases at the actual inflation rate.
• Real estate: residential and commercial real estate has long been considered the asset to purchase to hedge
against inflation.
• Commodities: commodities have long been considered an inflation hedge.
• Collectibles: many of the best inflation hedges are collectibles that trade at the more expensive end of the
market, such as classic cars, fine art and antiques.

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 SECTION 10

PORTFOLIO MONITORING,
RE-BALANCING, &
PERFORMANCE APPRAISAL

17 Portfolio Monitoring and Performance Evaluation

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 Portfolio Monitoring and
Performance Evaluation 17

CONTENT AREAS

What Is Portfolio Monitoring?

What Is Portfolio Performance Evaluation?

LEARNING OBJECTIVES

1 | Explain the steps in an effective portfolio monitoring system.

2 | Calculate a portfolio’s return.

3 | Evaluate the suitability of a benchmark.

4 | Compare the merits and drawbacks of different performance measurement and appraisal
methods.

5 | Evaluate the performance of a portfolio.

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 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 3

INTRODUCTION
The investment management process does not end when an investment advisor has selected securities for a
client’s portfolio. Investment advisors must monitor the markets and the client’s needs and goals, and should have
a monitoring system in place to ensure that they have the information they need when they need it. Performance
measurement not only helps investment advisors and clients monitor progress toward the client’s goals, but also
provides information about the success of particular strategies.
This chapter starts with a discussion about the issues involved in portfolio and client monitoring. Performance
evaluation, which involves performance measurement and performance appraisal, is discussed next. We examine
the methods involved in measuring performance and then discuss the ways in which portfolios can be appraised.

WHAT IS PORTFOLIO MONITORING?

Implementing a client’s portfolio is not the last step in the investment management process. Investment advisors
must continue to monitor the financial markets and the client’s needs, goals, and portfolio. Monitoring a client’s
portfolio does not imply that the investment advisor selected inappropriate securities or ignored client information.
Portfolio monitoring acknowledges that the markets and clients change and that both must be reviewed
periodically to ensure that the portfolio remains appropriate for the client’s situation.
How often should this information be reviewed? Changes in economic forecasts and the recommendations of
strategists and analysts affect clients’ portfolios in different ways. Clients who like to trade actively may need
frequent informal reviews, most of which take place during telephone conversations. Most clients, however, are
concerned about the long-term view. Daily and weekly reviews are not needed for these clients, and even monthly
reviews are uncommon. Quarterly reviews, or even annual reviews, are more appropriate.
Investment advisors need an effective monitoring system to ensure that they have the information they need when
they need it. Computerized contact management software is often helpful. Investment advisors should also ensure
that their clients understand the importance of informing them of any changes that affect their financial situation,
such as job loss, marital breakdown, death in the family, inheritance, a change in a company pension plan, or a
change in their willingness to bear risk.

EXAMPLE
If a client experiences a disabling accident and can no longer work, you may need to reconstruct the portfolio to
provide more income.

Changes in lifestyle or attitude can also affect investment policy. A workaholic client who planned to stay on the
job until 65 may suddenly decide to retire earlier and enjoy life, rather than save money for the children to use. This
change in philosophy will call for a review of the investment policy because the portfolio is now needed to fund a
lifestyle geared to enjoyment rather than to passing on an estate.
Changes in the economic environment, such as a rise or fall in market rates of return, may also call for a review.
Assets may have to be reallocated. The performance of individual investment vehicles must also be reviewed from
time to time to assess whether they are delivering, and will continue to deliver, a suitable return.
The following is an example of an effective monitoring system for an investment advisor:
1. Ensure that information affecting the client’s financial situation is up to date.
2. Ensure that all client contact information is up to date (home address, telephone numbers, etc.).
3. Determine how often meetings will take place to discuss the portfolio; this information should be outlined in
the client’s investment policy statement (IPS).

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4. Stay on top of forecasts for economic and financial markets. If forecasts change in a material way, a client’s
tactical or strategic asset allocation may be affected.
5. If a client has invested in managed products, review the performance of fund managers regularly. Pay close
attention to the managers’ performance over an economic cycle (approximately three to five years) and a five-
and ten-year time period. If there is a change in fund managers, it is also important to assess the impact of this
change.

During quarterly or annual client reviews, investment advisors should ask clients if their goals or personal
circumstances have changed in any way. Not all clients may be forthcoming and state that, for example, they have
been recently diagnosed with an illness. However, changes that affect the client’s goals are important to investment
advisors and should be disclosed by clients.

WHAT IS PORTFOLIO PERFORMANCE EVALUATION?

Performance evaluation is now an integral part of the decision-making process for most investment organizations.
Furthermore, in today’s highly competitive money management environment, clients have become more
demanding and evaluation techniques are more sophisticated.
Portfolio performance evaluation is based on two fundamental concepts. The first is that return is related to risk,
and thus performance of a portfolio cannot be evaluated on its return alone. For instance, assume a portfolio had
a 20% return in a given year and we want to assess the manager’s performance. We can legitimately say relatively
little. After all, its manager may have taken twice the risk of comparable portfolios to achieve this 20% return. The
primary reason is that investing is always a two-dimensional process based on return and risk, and both must be
evaluated if intelligent decisions are to be made. Therefore, if we know nothing about the risk of this portfolio, we
can say little about its performance.
The second cornerstone of evaluation is the view that passive and active management are two mutually exclusive
and exhaustive approaches to portfolio management. Active managers try to increase return through selectivity and
timing. Selectivity entails trying to consistently select undervalued securities. Timing involves adjusting portfolio
composition to anticipate market trends and includes modifying portfolio betas and durations, sector rotation,
and tactical asset allocation. If properly executed, any of these strategies will enhance returns. Nonetheless, active
management comes at a price: the portfolio could underperform a passively managed portfolio and transaction
costs increase with trading activity. Therefore, the return on the portfolio must be greater than that of a passively
managed portfolio to compensate for these extra costs.
The goal of passive management, on the other hand, is to capture only the returns from assuming systematic risk.
A buy-and-hold system is implemented without any attempt at stock selection or asset class timing. Indexing is
accomplished by holding the securities comprising the index in the same proportions as they are weighted in the
index itself. This method requires less portfolio turnover relative to an active management style. Consequently,
performance evaluation of a passively managed portfolio is essentially concerned with minimizing tracking error,
which is the standard deviation of the difference in returns between the index and the passively managed fund.
There are two stages in portfolio performance evaluation:

Performance involves the calculation of the return realized by a portfolio over a specific period of time
measurement called the evaluation period. Because only four fundamental types of transactions occur
within portfolios – security purchases, security sales, contributions, and withdrawals –
measuring return sounds as if it should be relatively straightforward. However, several
important points must be addressed in developing a methodology for calculating a
portfolio’s return.

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 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 5

Performance appraisal is an assessment of how well a portfolio has done over the evaluation period. Given
the costs clients incur to have their portfolios managed, they need to know if the cost
justifies the service. Thus, performance measurement and appraisal together yield a
cost-benefit analysis of the investment advisor’s recommendations.

Reporting on the performance of the portfolio requires more than simply a list of the securities held, their cost
base, and ending market value. Performance reporting evaluates the ability of the IA to achieve the risk and return
preferences of the client as stated in the investment policy.

PERFORMANCE MEASUREMENT
Most investment advisors and clients have access to in-house software that produces client portfolio reports. While
the format of these reports varies across firms, most provide the following information:
• A list of the portfolio’s securities as of the report’s date, including the name and amount of each security owned,
separated into at least three asset classes (cash, debt securities, and equity securities).
• The cost (or book) and market values of each security.
• Each security’s weight (based on market values) within the portfolio.
• Each security’s dividend or interest rate, annualized income, and current yield.

Measures of the portfolio’s return over specified historical periods may also be included in these reports or provided
on a separate report. Portfolio reporting systems allow investment advisors to combine several accounts into a
single report. This is useful when a client or client group (for example, a husband and wife) has more than one
account (for example, registered and non-registered).
Figures 17.1 and 17.2 show sample reports from an investment dealer. These are samples only. Actual reports, and the
details provided, vary by firm. Also, most firms have a glossary of terms available for their clients who want to know
more about the terminology used in their reports.

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Figure 17.1 | Sample Portfolio Report #1

A detailed list of the securities in the accounts of Paul and Phyllis Anderson as of January 31, 2018.

This portfolio combines holdings for the following clients: 15123456 Paul E. Anderson
15787878 Phyllis Anderson

CANADIAN ASSET MIX AS AT 31-JANUARY-2018

Cost Market % Of Annualized

Value Value Portfolio Income Yield

Total Cash and Cash Equivalents 7,450 7,450 37.25 0.50

Total Fixed-Income Securities 31,230 33,250 1,215 3.65

Total Common-Equity Securities 92,366 103,756 2,764 2.66

Total Canadian Portfolio 131,046 144,456 100.00 4,016.25 2.78

CANADIAN PORTFOLIO HOLDINGS AS AT 31 -JANUARY-2018

Cost Cost Market Market % Of Div($)/ Annualized Current

Holdings Security Price Value Price Value Portfolio Int (%) Income Yield

Cash and Cash Equivalents

2,450 CASH 7,450 7,450 5.16 0.50% 37.25 0.50

Total Cash and Equivalent 7,450 7,450 5.16 37.25 0.50

Fixed-income Securities

10,000 Province A 4.40% 08Mar20 102.50 10,250 110 11,000 7.61 4.40% 440 1.86

10,000 Canada 3.50% 01Jun22 107.50 10,750 112 11,200 7.75 3.50% 350 1.93

10,000 Province B 4.25% 01Dec23 102.30 10,230 110.50 11,050 7.65 4.25% 425 3.01

Total Fixed-Income Securities 31,230 33,250 23.01 1,215 3.65

Common Equity

400 LMN Gold Corp. 26.00 10,400 49.46 19,784 13.70 0.60 240 1.21

600 ABC Companies Limited 42.10 25,260 36.40 21,840 15.12 0.84 504 2.31

600 DEF Energy Inc. 22.76 13,656 34.54 20,724 14.35 0.44 264 1.27

1300 GHI Financial Corporation 13.50 17,550 11.71 15,223 10.54 0.52 676 4.44

500 JKL Bank of Canada 51.00 25,500 52.37 26,185 18.13 2.16 1,080 4.12

Total Common Equity 92,366 103,756 71.83 2,764 2.66

Total Canadian Portfolio 131,046 144,456 100.00 4,016.25 2.78

Information contained herein has been obtained from sources which we believe to be reliable but is not guaranteed.
Investment Advisor: Walter T. Allen
Date Printed: 20-February-2018

© CANADIAN SECURITIES INSTITUTE (2017)

 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 7

Figure 17.2 | Sample Portfolio Report #2

A portfolio returns report for Joe Smith as of December 31, 2017.

WEIGHTED RATES OF RETURN AS OF PERIOD ENDING 31-DEC-2017
Client: 66000001 Joe Smith I.A.: C12 Fred Allenby
Combined Report For: Client Current Market Value $ % of Overall Market Value
66000001 Joe Smith 135,000 100.00
Calendar Years % Rates of Return
2014 3.51
2015 10.06
2016 5.64
2017 19.21

AVERAGE ANNUAL COMPOUND RATE OF RETURN (%) FOR PERIOD ENDING 31-DEC-2017
Calendar Years % Rates of Return
1 Year 19.21
2 Year 12.22
3 Year 11.50
4 Year 9.44

2017 CALENDAR YEAR RATES OF RETURN

Period % Rates of Return Year-to-Date
January 2017 13.33 13.33
February 2017 0.21 13.57
March 2017 0.00 13.57
April 2017 0.00 13.57
May 2017 6.21 20.62
June 2017 0.00 20.62
July 2017 0.00 20.62
August 2017 0.62 21.37
September 2017 0.00 21.37
October 2017 0.00 21.37
November 2017 (1.78) 19.21
December 2017 0.00 19.21
First Quarter 2017 13.57 13.57
Second Quarter 2017 6.21 20.62
Third Quarter 2017 0.62 21.37
Fourth Quarter 2017 (1.78) 19.21
Information contained herein has been obtained from sources which we believe to be reliable but is not guaranteed by ABC Securities Inc.

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17 • 8 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 10

It is important to distinguish between these portfolio reports and the official record of the client’s holdings, which,
for clients of IIROC member firms, is communicated through statements produced in accordance with IIROC
Rule 200. These statements include not only a listing of the cash and securities in the account as of the statement
date, but also a list of transactions since the previous statement date. According to the regulation, statements must
be sent:
monthly for all customers who have effected [sic] a transaction, or if the [IIROC] Member has modified the
balance of securities or cash in the customer’s account, unless the entries refer to dividends or interest; quarterly
for all customers having any debit or credit balance or securities held (including securities held in safekeeping or
in segregation) at the end of the quarter.1

MEASURING PORTFOLIO RETURNS

Most portfolio reporting systems can calculate portfolio returns for different time frames, including the past month,
quarter, and year. Portfolio returns could be calculated using the returns on the securities in the portfolio. However,
this method is inappropriate because it assumes that the securities are held for the entire return measurement
period and does not allow for contributions to or withdrawals from the portfolio. (Contributions and withdrawals in
the form of either cash or securities are frequently referred to as portfolio cash flows.)
Computing the return on a portfolio (with or without cash flows) when securities are bought and sold during the
return measurement period means considering the total dollar value of the portfolio rather than the returns on
individual securities in the portfolio.
If there are no cash flows, then the portfolio’s return is simply the percentage change in its market value from the
beginning of the evaluation period to the end of the evaluation period, as in Equation 17.1.
MVE  MVB MVE (17.1)
RP   1
MVB MVB
Where:
MVE = the market value of the portfolio at the end of the evaluation period
MVB = the market value of the portfolio at the beginning of the evaluation period

EXAMPLE
If a portfolio had a market value of $500,000 at the end of March and $525,000 at the end of June, then its
three-month, or quarterly, return was 5%.
$525,000
RP   1  0.05  5%
$500,000

When there are cash flows, a portion of the change in the value of the portfolio is the result of the cash flows
themselves. For instance, if a portfolio is worth $100,000 at the start of the year and $150,000 at the end of the
year, and the client added $15,000 in cash to the portfolio during the year, then $15,000 of the $50,000 increase in
the value of the portfolio comes from the contribution, not return on investment.
The return on a portfolio is affected by both the amount and timing of portfolio cash flows. There are several ways
to deal with cash flows, and different portfolio reporting systems use different methods. Investment advisors should
know which method their firm’s system uses.

1
IIROC Rule Book, Rule 200.1(c).

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 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 9

One way to account for cash flows is to assume that all contributions occur at the beginning of the period and all
withdrawals occur at the end of the period. With these assumptions, Equation 17.2 can be used to calculate the
portfolio’s return.
MVE  MVB  Contributions Withdrawals (17.2)
RP 
MVB Contributions

Where:
MVB = the value of the portfolio just before any contributions
MVE = the value of the portfolio just after any withdrawals

The numerator of Equation 17.2 adjusts the change in the value of the portfolio by the amount of any contributions
or withdrawals. Since contributions increase a portfolio’s value and withdrawals decrease its value, the numerator
of Equation 17.2 isolates how much of the change was due to a return on the portfolio’s investments by subtracting
the value of the contributions and adding the value of the withdrawals from the change in the value of the portfolio.
The numerator of Equation 17.2 is therefore a measure of the dollar return on the portfolio’s investments net of any
portfolio cash flows.
To convert the dollar return to a rate of return, the dollar return is divided by the market value of the portfolio at the
beginning of the period plus the value of the contributions, because the contributions were used to earn part of the
return on the portfolio’s investments.

EXAMPLE
A portfolio has a market value of $500,000 at the end of March and $535,000 at the end of June. Suppose that
in early April, the owner of the portfolio contributed $10,000 to the portfolio. In this case, the dollar return
is $25,000, but the return on the portfolio is only 4.90% because the dollar return was earned on a larger
investment base.
$535,000  $500,000  $10,000 $0
RP 
$500,000 $10,000
$25,000

$510,000
 0.0490

 4.90%

As mentioned, Equation 17.2 assumes that contributions are received at the beginning of the period and withdrawals
are made at the end of the period. Some portfolio reporting systems calculate returns using this assumption. If,
however, contributions occur later in the period, or withdrawals occur earlier in the period, this method understates
the actual return. For example, if the investor in the above situation contributed the $10,000 just before the end
of the period, then 5% is a better measure (than 4.90%) of the actual return on the portfolio because the $25,000
dollar return was earned on a smaller investment base ($500,000 rather than $510,000).
If a portfolio reporting system can calculate returns based on a more precise timing of cash flows, then it will likely
use one of two methods: the dollar-weighted (or money-weighted) return or the time-weighted return.

DOLLAR-WEIGHTED RETURN
The dollar-weighted or money-weighted return measures the performance of the portfolio as experienced by the
investor. This performance is based not only on how well the portfolio’s investments do, but also on the amount
and timing of portfolio cash flows. As of July 15, 2016, IIROC mandates that investment dealers provide clients with
annualized returns using the money-weighted return.

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17 • 10 INVESTMENT MANAGEMENT TECHNIQUES | SECTION 10

EXAMPLE
Suppose a client’s portfolio is worth $500,000 on March 31. In April, the portfolio appreciates 8%, so that at the
end of April the portfolio is worth $540,000. On April 30, the client deposits $10,000, so that the portfolio is
now worth $550,000. In May, the portfolio declines by 5%, so that on May 31 the portfolio is worth $522,500.
On May 31, the client deposits an additional $22,500, so that the portfolio is now worth $545,000. In June, the
portfolio appreciates 10%, so that on June 30, the portfolio is worth $599,500. The following table summarizes
the portfolio values and cash flows.

Portfolio Value Portfolio Value

Date Before Contribution Contribution After Contribution
March 31 — — $500,000
April 30 $540,000 $10,000 $550,000
May 31 $522,500 $22,500 $545,000
June 30 $599,500 — —

The first step in finding the dollar-weighted return is to determine how long each of the contributions were
invested in the portfolio (or how long each of the withdrawals were out of the portfolio) relative to the total
length of time for which the rate of return is being measured.
In the example, the first contribution, $10,000 on April 30, was invested for two of three months, which is
two-thirds of the return measurement period. The second contribution, $22,500 on May 31, was invested for
one month or one-third of the period. The dollar-weighted return (DWR) is the value that solves the following
equation:
[$500,000 × (1 + DWR)1] + [$10,000 × (1 + DWR)0.67] + [$22,500 × (1 + DWR)0.33] = $599,500

Using trial and error or a financial calculator, the dollar-weighted return would be 13.04%.

The dollar-weighted return is an internal rate of return that equates the ending value of the portfolio to the
beginning value of the portfolio and all portfolio cash flows.2 In essence, it is a time value of money problem that
solves for the discount rate, which in this case is the portfolio return.
Internal rates of return are used extensively in several different investment applications. For example, the yield to
maturity on a bond is an internal rate of return that equates the price of the bond to the bond’s coupon rate and
maturity value. In almost all cases, it is not possible to solve directly for an internal rate of return; rather, a trial-and-
error process is required. An alternative to guessing is to use a financial calculator or spreadsheet program (which
uses the same process but does it much faster).
The dollar-weighted return is strongly influenced by the client’s decision to contribute to or withdraw money from
the portfolio. We can show this with a simple example.

EXAMPLE
Suppose a portfolio is worth $500,000 on March 31, as in the previous example. In each month, the portfolio
is invested in the same securities with the same weighting as the portfolio in the previous example, so that
the monthly returns are 8%, –5%, and 1 0%. This time, however, the investor contributes $22,500 on April
30 and $10,000 on May 31, which is exactly opposite to the pattern of contributions in the previous example.
The following table summarizes the portfolio values and cash flows.

2
Alternatively, we can set up the problem so that we are trying to find the return that equates the beginning value to the ending value and all
portfolio cash flows.

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 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 11

EXAMPLE
Cont'd
Portfolio Value Portfolio Value
Date Before Contribution Contribution After Contribution
March 31 — — $500,000
April 30 $540,000 $22,500 $562,500
May 31 $534,375 $10,000 $544,375
June 30 $598,813 — —

Even though the portfolio was invested in exactly the same manner as the other portfolio, the ending value is
almost $700 less. The discrepancy is due entirely to the fact that the second investor made the larger of the
two contributions just before May, which was the only month with a negative return. The smaller contribution
was made just before June, which was the month with the best return. The timing of these transactions led this
investor to underperform the other investor by almost $700.
The dollar-weighted return of this portfolio is the value that satisfies the following equation:
[$500,000 × (1 + DWR)1] + [$22,500 × (1 + DWR)0.67] + [$10,000 × (1 + DWR)0.33] = $598,813

Using a financial calculator or spreadsheet reveals that the dollar-weighted return in this case is 12.80%.
Using your financial calculator (Sharp EL-738), complete the following steps:
First, clear previously entered data by pressing CFi then 2ndF then CA
Next, enter the cash flow data
-500,000 then press DATA
-22,500 then press DATA
-10,000 then press DATA
598,813 then press DATA
Then Press 2ndF then CASH then 2ndF then CA
Press COMP (calculate IRR)
Answer: 4.0979%
To find out the answer based on this one period result produced by the calculator, raise the result by the power
of 3, which represents the 3-month period:
= (1 + r)n –1
= (1 + 0.040979)3 – 1
= (1.040979)3 – 1
= 1.1280 – 1
= 0.1280 or 12.80%

A final thing to note about dollar-weighted returns is that they assume a level return across the measurement
period.

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TIME-WEIGHTED RETURN
Unlike the dollar-weighted return, the time-weighted return eliminates the effect of portfolio cash flows
and measures only the cumulative performance of the portfolio’s investments. If an investment advisor has
recommended all the securities in a client’s portfolio, then the time-weighted return measures the performance
of the investment advisor’s recommendations. Since the investment advisor cannot control when a client deposits
or withdraws money, it is not appropriate to use the dollar-weighted return to measure the performance of the
investment advisor’s recommendations.
The following steps are used to calculate the time-weighted return:
1. Using Equation 17.1, calculate the total return on the portfolio from the beginning of the period to the point at
which the first cash flow occurs. The MVB is the value of the portfolio at the beginning of the period, while the
MVE is the market value of the portfolio just before the cash flow is received.
2. Using Equation 17.1, calculate the total return on the portfolio from just after the first cash flow is received to
just before the next cash flow. The MVB in this case is the value of the portfolio just after the first cash flow is
received, while the MVE is the value of the cash flow just before the next cash flow.
3. Repeat this process to the end of the return measurement period. At that point, use Equation 17.1 to calculate
the total return from just after the last cash flow to the end of the return measurement period.
4. Calculate the time-weighted return (TWR) from the sub-period returns using Equation 17.3.

TWR  ¡¢ 1 R1 q 1 R2 q ... q 1 RN ¯°±  1 (17.3)

Where:
RN = the portfolio’s total return during sub-period n
N = the number of sub-period returns

The time-weighted return is a geometric linking of the individual sub-period returns. As such, the time-weighted
return is the total return on the dollars that have been invested in the portfolio for the entire period. Compared to
the dollar-weighted return, the time-weighted return is relatively easy to calculate.
The following tables provide the same information about cash flows as the two portfolios presented in the dollar-
weighted return section as well as the sub-period return calculations. The first portfolio had the values and cash
flows in the following table:

Portfolio Value Portfolio Value

Date Before Contribution Contribution After Contribution
March 31 — — $500,000
April 30 $540,000 $10,000 $550,000
May 31 $522,500 $22,500 $545,000
June 30 $599,500 — —

The sub-period returns are calculated as follows:

Sub-period Return
1 (April) ($540,000 / $500,000) – 1 = 0.08
2 (May) ($522,500 / $550,000) – 1 = –0.05
3 (June) ($599,500 / $545,000) – 1 = 0.10

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 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 13

The second portfolio had the values and cash flows in the following table:

Portfolio Value Portfolio Value

Date Before Contribution Contribution After Contribution
March 31 — — $500,000
April 30 $540,000 $22,500 $562,500
May 31 $534,375 $10,000 $544,375
June 30 $598,813 — —

The sub-period returns are calculated as follows:

Sub-Period Return
1 (April) ($540,000 / $500,000) – 1 = 0.08
2 (May) ($534,375 / $562,500) – 1 = –0.05
3 (June) ($598,813 / $544,375) – 1 = 0.10

Because the sub-period returns for each portfolio were the same, the time-weighted return for each portfolio is the
same and is equal to:
(1.08 × 0.95 × 1.10) –1 = 0.1286 = 12.86%

One problem with the time-weighted return calculation is that the reporting system needs the value of the portfolio
on each day a cash flow occurs. If a portfolio reporting system is not set up to store this information, it will not be
able to calculate the time-weighted return.

PRE-TAX VS. POST-TAX RETURNS

Performance evaluation uses returns earned prior to taxes because tax regimes are irrelevant for most managed
money (e.g., income earned within a pension fund is tax-exempt), and in taxable situations it is felt that revenue
streams from active and passive portfolios will be similar enough that trying to adjust for a variety of tax rates is not
worth the effort. However, when managers’ actions affect the tax burden on portfolio investors, tax considerations
may be necessary. This occurs, for instance, when the realized components of return have to flow through to
investors to avoid taxes being levied on the portfolio. The best example is a mutual fund.
With a mutual fund, the after-tax returns to taxable shareholders become lower the greater the proportion of return
from distributions. Part of the distributions are the net capital gains (capital gains less capital losses) realized by the
fund. If a fund takes capital gains solely when it has offsetting capital losses, taxable investors will pay capital gains
tax only when shares are redeemed (assuming the shares have increased in price). If a fund realizes capital gains and
distributes them, the fund forces shareholders to pay tax during that particular taxation year on gains even though
the shares were not redeemed. The main cause of realizing capital gains is active management.
Higher turnover means greater capital gains distributions. While not all capital gains are triggered by a manager’s
trading decisions to improve the portfolio (redemptions outrunning sales can be a source, as can mergers and
takeovers), most turnover arises as managers time the market and pick securities. Thus, a passive investment
strategy becomes more appealing on an after-tax basis, but this is missed by performance comparisons. Adjusting
the fund’s returns to an after-tax basis is straightforward given a hypothetical capital gains tax rate. In addition,
the fund could present returns based on a range of rates. Say a capital gains tax rate is 40%, then 60% of a capital
gains distribution can be treated as reinvested into the fund rather than the usual 100% used in computing return.
Unfortunately, deriving after-tax benchmarks is complex because an investment period with final liquidation needs
to be assumed. Capital gains distributions advance the tax burden but do not create it. While investment return
is lost by paying the taxes early, the benchmark has to recognize that capital gain taxes are deferred, not avoided.

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Since investors have different starting points to establish the cost base, no single benchmark is suitable for all
investors even if they all have the same tax rate.
To further complicate matters, passive benchmarks implicitly force investors to take capital gains. Rebalancing
to keep the index contents and weights on track (some benchmark indexes are rebalanced frequently) generally
implies net capital gains. Holders of index mutual funds experience this effect first-hand. Benchmark returns
overstate returns to taxable investors, which partially offsets the after-tax measurement problem of managed
portfolios. At this time, perhaps the best that can be done when taxes are not avoidable and the portfolio distributes
capital gains is just to recognize the problem.

PRE-FEES VS. POST-FEES RETURNS

An important question is whether the returns are presented before or after management fees. Mutual fund returns
are calculated net of fees (after fees have been deducted), but returns on other managed portfolios are typically
reported gross of fees (before fees have been deducted). A return gross of fees reflects a manager’s raw performance
but is not the return of importance to investors.
Providing returns without subtracting the manager’s fees has two important implications. First, a portfolio
manager’s performance is not comparable to other managers’ returns. The amount of value that a manager
adds depends strictly on net returns exceeding the benchmark return. If the benchmark is a group of competing
managers, the group is impossible to rank unequivocally by performance because some managers charge more than
others for their services. The difference between performance-based fee structures (a manager’s payment is directly
related to how well the portfolio performs) and asset value–based charges (the fee is calculated on portfolio size,
not performance) also contributes to return comparison incompatibility. Returns gross of fees for performance-
based fee structures generally overstate superior performance to a greater degree than asset value–based fees
because a larger fee would be paid to the performance-based manager when the portfolio performs well. When
portfolio performance is poor, the performance-based portfolio manager will receive a lower fee. Therefore, in a
scenario of poor performance, the returns gross of fees will understate the performance-based manager’s return to
a greater degree than the asset value–based manager’s return.
The second important implication of performance gross of fees is that when the benchmark is a passive portfolio,
the return should be net of fees. When we say a manager has to add value, we more precisely mean net added
value. Investors want more risk-adjusted return than it costs to produce; otherwise there is no reason to pay for
active management.

PERFORMANCE APPRAISAL
After obtaining the relevant return data for a client’s portfolio, the investment advisor and client should evaluate
the quality of the portfolio’s returns. This part of the performance evaluation process involves the use of one or
more of the following methods: benchmark comparisons, performance universes, performance attribution, or risk-
adjusted return measures.

BENCHMARK COMPARISONS
The primary purpose of a benchmark portfolio is to set a realistic, attainable performance standard.
A portfolio’s strategic asset allocation can be used to construct a benchmark against which the portfolio’s
performance can be measured. The return on the benchmark portfolio for most individual investors is based on
the returns on well-known market indexes.

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 CHAPTER 17 | PORTFOLIO MONITORING AND PERFORMANCE EVALUATION 17 • 15

EXAMPLE
A client has a strategic asset allocation of 5% cash, 40% Canadian debt securities, and 55% Canadian equity
securities. The client’s investment policy statement requires the debt and equity allocations to be broadly
diversified, so the return on the FTSE TMX Canada Universe Bond Index is used as the debt securities benchmark
and the return on the S&P/TSX Composite Index is used as the equity securities benchmark. The return on the
FTSE TMX Canada 91 Day T-Bill Index is used as the benchmark for the cash allocation.
Over a particular evaluation period, the client realized a return of 8.50%. Over the same period, the returns on
the three indexes were as follows:
S&P/TSX Composite Total Return Index 9.5%
FTSE TMX Canada Universe Bond Index 6.7%
FTSE TMX Canada 91 Day T-Bill Index 1.0%

Thus, the return on the benchmark portfolio was 7.96%.

Return on Benchmark  0.05 q 1.0% 0.40 q 6.7% 0.55 q 9.5%

 0.05% 2.68% 5.23%

 7.96%
Because the client’s portfolio had a return greater than the benchmark return, the portfolio outperformed its
benchmark.

An investor can easily replicate the performance of the benchmark portfolio by investing in index mutual funds or
exchange-traded funds. In this way, using an index as a proxy for an asset class, an investor can determine what his
or her asset allocation should have earned if it had been passively managed. This return becomes the benchmark for
the actual performance of the portfolio. Setting up a benchmark allows the investor to measure the value added to,
or subtracted from, the portfolio based on the investment decisions.
Over the long term, a client should expect to realize the benchmark return from an asset class simply by being
invested in that asset class. If a client is unable to at least match the returns of a passively managed benchmark,
then the extra fees associated with active management have been wasted since the investor could have simply
replicated the performance of the benchmark using low-cost index funds or exchange-traded funds. At the end of
the day, an investment advisor’s recommendations must add value for the client.

REQUIRED CHARACTERISTICS OF BENCHMARKS

Benchmark choice is critical as it has a direct impact on measuring a manager’s investment skills. The wrong choice
can lead to incorrectly punishing a good manager or inappropriately rewarding a poor one. A good benchmark fairly
evaluates the manager and provides a passive alternative. Such a benchmark has the following basic characteristics:

Investable A benchmark is a passive investment alternative. The client can always choose to
forgo active management and simply hold the benchmark. This is important because it
captures the active/passive choice concept.

Unambiguous in The securities comprising the benchmark and the weighting scheme must be clearly
composition defined. Without knowing how the benchmark is constructed, it becomes impossible to
passively replicate the standard.

Appropriate The benchmark has the same risk as the portfolio and is consistent with the manager’s
investment style or biases.

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Attainable by manager The manager has current investment knowledge of the securities that make up the
benchmark and can invest in all securities. It is important that the portfolios chosen
for comparison are truly comparable. This means that they not only must have similar
risk, but also must be bound by similar constraints. For example, an institution that
restricts its managers to investing in bonds rated AA or better should not evaluate its
managers by comparing their performance with the performance of portfolios that are
unconstrained.

Specified in advance The benchmark is operational before the start of an evaluation period. This reduces the
chances of biased benchmark selection and makes the benchmark investable.

Objectively The benchmark is not tilted in favour of or against the manager. Objective, systematic
constructed building rules must determine benchmark values under all circumstances.

Easily measurable It is possible to readily observe performance to calculate the benchmark return on a
reasonably frequent basis.

CLASSES OF BENCHMARK PORTFOLIOS

Because of the increasing emphasis in recent years on measuring investment managers’ performance against
benchmarks that are indicative of a client’s portfolio and that match the manager’s style, the number of benchmark
indexes available has grown substantially.
In practice, four classes of benchmarks have been used:
1. Composite market indexes
2. Investment style benchmarks
3. Normal portfolios
4. Sharpe benchmarks.

The widely quoted composite market indexes are the best-known type of benchmark portfolio. These published
market indexes are designed to measure the movements of specified markets, not benchmark performance.
Although an index may be very good at what it was intended to do, it may not be suitable for evaluating managers.
For instance, not all market indexes are available in total-return form, that is, with reinvested distributions. Because
portfolio performance is reported with distributions reinvested, non-total-return indexes understate the total return
and bias the outcome in favour of the manager.
Another incompatibility is lack of style matching. Using a broad market index rather than a narrowly defined
benchmark portfolio is appropriate when either the portfolio manager does not have an investment style or the
manager practises a mixture of styles that the index mirrors. Even if the manager claims not to have a style, a style
analysis along the lines of the Sharpe benchmark methodology should probably be done to confirm style neutrality
and therefore the suitability of the index. On the other hand, some managers employ more than one style. The S&P/
TSX Composite Index, for example, could be considered for a manager who combines growth and value styles.
Customized investment style benchmarks are developed to reflect more closely the behaviour of the kinds
of securities in which the manager specializes. They are for portfolios that have highly specific return and risk
requirements that are not closely tracked by composite indexes. A type of customized benchmark is an investment
style index developed by various consulting firms to measure particular investment concentrations. For example,
a manager may concentrate on small-capitalization stocks, be growth oriented, and so on. While style indexes
address many of the concerns about market composites not representing the risks or opportunities of specialized
managers, style indexes have their own unique problems.

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Suppose a growth style index is required. There is no definitive way to define a growth stock as opposed to a value
stock, but the construction of indexes requires the formulation of growth and value. For instance, should value be
defined in terms of dividend yield or the price/book ratio? If price/book is used, what is the threshold value below
which a stock can be considered a value stock? A growth or value style index is strictly definitional and different
constructions apply different definitions. Even with large versus small capitalization, to which numbers can be
applied, the apparent objectivity is not as precise as it seems. For example, is small-cap market value under $100
million or some other value? Consequently, a style index may not be as closely matched to the portfolio being
evaluated as it first appears.
Another problem with using style indexes is the difficulty in classifying a money manager by a particular investment
style. To illustrate this point, suppose a money manager buys high– dividend yield stocks, selecting one half of the
portfolio from the top 100 firms (in market capitalization) of the S&P/TSX Composite Index and the other half from
the bottom 100 stocks in the index. Hence, stocks chosen from the index have a high dividend yield, a characteristic
of stocks selected by a value manager, and thereby classifying the manager as having a value style. At the same
time, the stocks selected from within the top 100 of the index are the largest-capitalization stocks; the manager
could therefore be classified as following a large-company style. However, half of the portfolio consists of small-
capitalization stocks and the manager could equally be classified as following a small-cap style. This imprecision has
led some involved in the investment management industry to argue that normal portfolios or Sharpe benchmarks
are more suitable.
A normal portfolio is a specialized benchmark that includes all the securities that a manager normally selects from.
In other words, the portfolio manager’s natural habitat is defined, and from that a normal portfolio is constructed
to serve as a benchmark. For example, if the manager typically chooses investments from a population of 300 value
stocks, the manager’s performance is compared with the performance of that universe of value stocks. The securities
are weighted as the manager would weight them in a portfolio, or the weights are picked such that the risk of the
benchmark is close to the risk of the portfolios the individual has managed in the past.
Advocates claim that normal portfolios are more appropriate benchmarks than market or style indexes because
they control for multiple investment styles. Normal portfolios more precisely define the security universe in which
the manager invests. In effect, the manager is being challenged to beat their own average.
It is neither an easy nor a costless process to construct normal portfolios. Defining the set of securities to be
included in the benchmark is based on discussions between the client and the manager and on analysis of historical
portfolios overseen by the manager. The selected set contains only securities the manager considers compatible
with their own style.
Given these securities, the next question is how they should be weighted in the normal portfolio. Determining this
typically involves a statistical analysis of the historical holdings of the manager and the risk exposure contained in
those holdings. A weighting scheme (market value-weighted, price-weighted, or equal-weighted) is applied to the
normal portfolio securities to produce risk closest to the historic risk the manager has used. Another methodology
measures the sensitivity of the historical portfolios to various factors defined by a factor model and determines the
set of weights that replicates these factor exposures for the normal portfolio. With either approach, the benchmark
portfolio may need frequent rebalancing to stay on track.
Clearly, the construction of a normal portfolio for a particular money manager is no simple task. A client must
recognize that there is a cost to developing and updating a normal portfolio. Moreover, there is not yet any sound
empirical evidence that normal portfolios are better or worse in explaining performance than style indexes.
Because of the difficulty of classifying a portfolio manager into any one of the generic investment styles, William
Sharpe suggested that a benchmark could be constructed by combining a variety of style indexes. A Sharpe
benchmark is created statistically using multiple-regression analysis. The average active return over a number of
sub-periods can be tested for statistical significance, and the constancy of a portfolio’s style can be examined by
rolling estimates (i.e., periodic re-estimation of the benchmark).

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The quality of the Sharpe benchmark depends on the relevance of the generic style indexes selected as candidates.
For example, when Sharpe introduced this technique, he suggested considering 10 mutually exclusive indexes
representing large-value and large-growth stocks, small-cap stocks, foreign stocks, money market securities,
mortgages, intermediate- and long-term federal bonds, government bonds (excluding federal), and corporate
bonds. Although not all of the indexes would be included in the estimation set for every portfolio, one has to start
with a generous number to capture unexpected relationships. For instance, a portfolio with many utility stocks
may behave like a passive portfolio invested in stocks and bonds, because regulation causes utility stocks to have
features that are both stock-like and bond-like. In practice, the final set of significant style indexes rarely contains
more than four. On the other hand, more than one style index is normally needed, demonstrating that most
managers practice several styles.
In addition to performance evaluation, the Sharpe benchmark methodology is useful for style analysis. Style
analysis classifies a manager’s actual investment pattern. It enables a sponsor to verify whether a prospective
manager was actually consistently implementing the claimed investment style in the market. Moreover, style
analysis can assist sponsors in developing performance evaluation benchmarks that more closely reflect a manager’s
investment style. Finally, an important role for style analysis is in helping sponsors monitor the manager’s
investment properties to reduce style drift.
Style drift occurs when managers stray from their intended style. It may be related to picking up some extra
return by moving into another style category, it may be because the manager does not have a precise view of
what securities fit the asserted style, or it may be caused by inattentiveness and not removing from the portfolio
securities that have gravitated out of the style habitat. Whatever the reason, the client is not getting what is being
paid for.
Sharpe benchmarks, like other evaluation procedures, have some drawbacks. One is that statistical models are
notoriously unstable. When style measures vary over time, it is not always clear whether it is a result of shifting
styles or the changeability of underlying statistical relationships. In addition, style indexes are often highly
correlated with each other, making it statistically difficult to separate their unique contributions.
Another problem is that analysis of past returns cannot capture the style of a manager who changes investment
strategy. Some time has to pass before a change in the style coefficients can be observed, meaning it takes a while
before the analysis catches up to the manager and, until it does, the benchmark will not be appropriate.

PROBLEMS WITH BENCHMARK PORTFOLIOS

A problem arises with index construction, especially with style indexes. For example, some stocks defined as value
stocks by those maintaining a value index will become growth stocks, or at least not value stocks anymore, as prices
change. Unless the index is rebalanced regularly, it will suffer style drift and become increasingly inappropriate for
benchmarking value portfolios. Repeated rebalancing, however, moves the index into the semi-passive category
with trading requirements and transaction costs nearly on par with active management.
A more serious issue is the changes to investment management behaviour that benchmarks induce. Defining
a benchmark index brings into play a manager’s natural tendency to manipulate their portfolio to align with
the benchmark. One way of achieving this is to become a closet indexer. Managers know that penalties for
underperforming are more severe (they can be fired by the client) than rewards for outperforming, particularly with
asset value–based fee structures. This produces incentive to avoid the risks inherent in security selection and market
timing and instead mimic the benchmark. The benchmark’s industry, economic sector, or even individual stock
weights (or duration, credit quality, or issuer in bond benchmarks) are duplicated fairly closely to avoid straying too
far from the benchmark (with the knowledge that no one will lose their job if only enough activity is undertaken to
cover management fees).
A second way to manoeuvre performance is to hold assets that are not part of the benchmark universe. In effect,
the manager intentionally reduces the relevance of the benchmark to make the portfolio’s performance seem
better. For instance, a large-cap equity manager may move part of the portfolio into small companies if an
opportunity for improving performance is seen there. A manager being graded against a bond index may hold

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mostly mortgage-backed securities if they are doing well, or a manager trying to beat the Europe, Australasia, and
Far East (EAFE) Index may include emerging market investments. If the manager has properly anticipated extra
return from outside the normal set of securities, the benchmark is outperformed and the manager looks good.
However, the added performance has not come from security selection or market timing within the universe, but
from perceiving the designated style will be out of favour. Measuring the manager against a benchmark appropriate
for style switching may even indicate underperformance. Managers playing this game are taking on what is termed
benchmark risk, because the excursion outside of the standard universe of securities can be taken at the wrong
time so that they appear considerably less skilled than their more conservative competitors.
Finally, benchmark portfolios have their own problems when measuring return. The first is the handling of
transaction costs. Every time the index is rebalanced, transaction costs are implied. If the benchmark is to represent
a legitimate alternative to the portfolio under evaluation, to keep the comparison fair, reasonable transaction
costs incorporating the initial investment and ongoing rebalancing have to be deducted from returns. Without an
adjustment for transaction costs, the benchmark is biased against the manager.
Most money managers hold cash on a regular basis, even those who describe themselves as fully invested. In
contrast, most plan sponsors and consultants are reluctant to permit cash to be included in manager benchmarks.
The exclusion of cash from the benchmark overstates benchmark returns in strongly rising markets, understates it in
down-trending markets, and interferes with trying to detect the manager’s skill signal. It is really a style issue: many
managers like to keep some of the portfolio in cash and if the sponsor does not like this, another manager should
be hired. If a manager who prefers to maintain a cash balance is retained, then the manager’s long-run cash position
should be included in the benchmark.

COMPARISON OR PERFORMANCE UNIVERSES

One way of achieving meaningful performance evaluation is to compare a portfolio’s return with the performance
of a large number of other portfolios with similar risk characteristics. The collection of portfolios that form the basis
for comparison is called a comparison or performance universe.
Comparison universes are constructed by performance appraisal services. The appraisal firms collect performance
information from a large number of managed portfolios and customarily display the information in the form of a
chart such as the one presented in Figure 17.3. In each period, the portfolios (and their managers) are ranked by
return and by industry convention. Managers are generally ranked by quartile, where each quartile contains 25% of
the population observed. The first quartile represents the managers whose portfolios achieved the best performance
of all managers observed, and the fourth quartile represents the managers whose portfolios achieved the worst
performance of the group. Second quartile shows the second best group of managers and third quartile shows the
third best group of managers.
A manager’s portfolio falling into the area above the top dotted line has produced first quartile performance and a
manager’s portfolio placing below the bottom dotted line has suffered bottom quartile performance. This type of
information shows how well all managers did (by position of the rectangle) and the dot in each bar represents the
performance of the manager being evaluated. Data presented in Figure 17.3 allow the sponsors to evaluate how
their fund managers compare with a universe of managers on a return basis. The information is ordinarily updated
quarterly. Similar data on how the manager places with respect to risk, commonly measured by variability of return,
may also be presented.

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Figure 17.3 | Comparison Universe

25%

20%

15%
Return (%)

10%

5%

0% ABC Portfolio

-5%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Period

The performance of a particular portfolio is presented on a percentile basis, with the top quartile represented by the
space above the top dotted line and the bottom quartile below the bottom dotted line. The median is the solid mid-
line where 50% of the managers’ performance were better and 50% of the managers’ performance were worse.

PROBLEMS ASSOCIATED WITH COMPARISON UNIVERSES

The contents of many comparison universes are poorly defined, so that the client does not know exactly what the
portfolio is being compared against. For example, a balanced fund universe may contain everything from equity
funds with a modest bond component to bond funds with small stock exposures, while a competitor’s universe
restricts itself to a minimum 25% stock or bond portion.
Broad performance universes also do a poor job of accounting for risk. If the universe is one of equity portfolios,
then managers who concentrate on particular subgroups such as small-capitalization firms or low-beta stocks will
have different risk characteristics than the universe. Similarly, general bond universes are not representative of
managers specializing in high-yield bonds or short-duration portfolios.
Therefore, a portfolio’s performance is being assessed relative to other funds that undertake different risks. In
other words, the benchmark is not appropriate. Nonetheless, suppose the median performer is viewed as a viable
benchmark representing the “typical” portfolio. The manager’s ranking by risk is usually available, but is the fund
with median risk also the median performer? Risk-adjusted comparison is impossible.
Universe providers are responding to concerns about mismatched risks and creating sub-universes to represent
more closely a manager’s style, such as small- and large-capitalization equity sub-universes. Even finer partitioning
may be offered, such as small-cap growth and small-cap value subgroups; however, as sub-universes move closer
to precisely defined managerial styles, they quickly shrink in size and thereby raise questions about the statistical
reliability of any comparison. It is even more difficult to partition fixed-income universes. For example, fixed-income
portfolio managers’ duration choices range significantly so that grouping categories by default-risk, class, or
duration would lead to unacceptably small sub-universes. In fact, because of the lack of widely available manager
sub-universe comparisons, many fixed-income portfolio managers rely on various bond indexes as representative
benchmarks for assessing style differences.
Furthermore, the returns used in performance universes are gross of management fees, making it impossible
to determine net value-added performance. Because of the range of fees charged, the rankings could change

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considerably if a net of management fee return comparison were possible. To a lesser extent, the same applies to
administrative costs, which also vary across funds.
Survivorship bias is also a part of all comparison universes in some form, no matter how carefully they are
constructed. As defunct portfolios drop out, they have to be excluded from rankings in subsequent quarters;
therefore, a performance universe is always a universe of survivors. As unsuccessful funds typically are terminated
or cease to exist, there is an upward bias in the longer-run cumulative returns. For illustration, suppose a manager
has median performance every quarter. With survivorship bias, the three-, five-, and ten-year return comparisons
will show the manager in the bottom half of the universe with deteriorating performance as the investment
period lengthens. This benchmark creep makes average and moderately good managers look like ever-increasing
underperformers as the historical period involved in a comparison lengthens.
Universe construction and compilation is similar across appraisal services, but each has its own methodology. The
differences are substantial enough that a manager may rank in the top half of managers in one universe and fall into
the bottom half in a competing universe. For example, one vendor may sample money managers to make the data
available as quickly as possible, while a competitor reports the population. The first approach introduces sampling
error, even with a random sample, and the error is magnified if the sample is not random. Another difference arises
from the treatment of managers overseeing more than one portfolio. Some firms will include multiple results from
the same manager, while others use one composite number per manager. In the former, the larger managers with
a greater number of funds under management have greater proportionate weighting in determining the median or
quartile breaks.
Finally, universe comparison still suffers from a structural defect. One of the characteristics of a good benchmark is
that it be investable. Suppose a client compares a manager’s performance with that of the median manager. Such
a benchmark is not investable because no one knows beforehand who the median manager will be. Moreover, the
median manager changes from period to period. The median portfolio for the quarter is probably different from the
one for the year and different again from the five-year evaluation. Universe comparison does not present a passive
investment alternative to a manager under review.

PERFORMANCE ATTRIBUTION ANALYSIS

The purpose of performance attribution is to decompose the total performance of a portfolio into specific
components that can be associated with particular decisions made by the client and the portfolio manager. The
results of the analysis pinpoint how well the manager is doing and whether the chosen policies are good or should
be modified. It also allows the client to determine if the manager’s stated strategy for gaining superior return
is in fact the applied strategy. For example, suppose a manager hired on the claimed skill of being able to find
underpriced stocks does exceed the benchmark portfolio return. However, when the return realized by the manager
is segregated into the various components that generated the return, the sponsor may find that the superior
performance is the result of the manager’s timing of the market and not from the proposed intended strategy.

POLICY RETURN, ALLOCATION RETURN, AND SELECTION RETURN

Performance attribution begins with the investment policy statement that guides the management of the portfolio.
The first step in attribution analysis is to determine the portfolio’s policy return. A portfolio’s policy return is equal
to the return on the portfolio based on the strategic asset allocation decision. For example, suppose a Canadian
balanced portfolio’s strategic asset allocation is 60% equity, 35% fixed income, and 5% cash. The benchmark
for the equity portion is the return on the S&P/TSX Composite Index, while the benchmarks for the fixed-income
and cash portions are the FTSE TMX Canada Universe Bond Index and the FTSE TMX Canada 91 Day T-Bill Index,
respectively. If the S&P/TSX Composite returned 12.4%, the FTSE TMX Canada Universe Bond Index returned 6.3%,
and the FTSE TMX Canada 91 Day T-Bill Index returned 1.0%, the Canadian balanced portfolio’s policy return is
equal to the following:
Policy Return = (0.60 × 12.4%) + (0.35 × 6.3%) + (0.05 × 1.0) = 9.70%

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The next step in attribution analysis is to measure the return on the portfolio based on the decision to shift the
portfolio’s weights from the strategic asset allocation, which is called the portfolio’s allocation return. The decision
to deviate a portfolio’s weights from the strategic allocation can be made by the client or it can be left to the
discretion of the manager. If it is at the discretion of the portfolio manager, then the allocation return is included in
the evaluation of the portfolio manager. For example, suppose that the manager of the Canadian balanced portfolio
decided to overweight equities and underweight fixed income such that the portfolio was actually weighted 65%
equity, 30% fixed income, and 5% cash. The portfolio’s allocation return is equal to the following:
Allocation Return = (0.65 × 12.4%) + (0.30 × 6.3%) + (0.05 × 1.0) = 10.00%

This difference between the policy return and the allocation return is referred to as the allocation effect.
RAllocationEffect  RAllocation  RPolicy (17.4)

For the balanced portfolio, the decision to overweight equities turned out to be a good one because the portfolio
earned 0.30% more from this allocation than if it had stuck with its strategic allocation.
The final decision is to measure the portfolio manager’s ability to select individual securities, which is known as the
selection effect. For example, suppose that the actual return on the Canadian balanced portfolio was 10.07%. The
manager’s contribution is equal to the difference between the actual portfolio return and the allocation return.
RSelectionEffect  RPortfolio  RAllocation (17.5)

For the balanced portfolio, the manager’s contribution equals 0.07%. This incremental gain in the portfolio above
the allocation return means that the portfolio manager was able to select securities that outperformed the
benchmarks based on the actual asset allocation of the portfolio. Based on equations 17.4 and 17.5, a composite
formula that breaks down the return on the portfolio into its various components can be written.
RPortfolio  RPolicy RAllocationEffect RSelectionEffect (17.6)

The balanced portfolio’s total return of 10.07% is equal to the policy return of 9.70% plus the allocation effect of
0.30% plus the selection effect of 0.07%.

RISK-ADJUSTED RETURNS
Risk-adjusted return measures compare the returns generated by a fund to the level of risk taken to earn those
returns. Because they incorporate both the risk and return of a fund, they can be used to compare funds with
different investment mandates.

JENSEN’S ALPHA
Jensen’s alpha quantifies the degree to which a manager has added value relative to the market given the
portfolio’s systematic risk, and is calculated as follows:
JP  RP  RF  ¡¢ CP q RM  RF ¯°± (17.7)

Where:
JP = Jensen’s alpha
RP = the average return on the portfolio over a specified evaluation period
RF = the average risk-free return over a specified evaluation period
RM = the average return on the market index over a specified evaluation period
BP = the portfolio’s beta over a specified evaluation period

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Jensen’s alpha is a measure of the manager’s performance. If Jensen’s alpha is positive, the manager has produced
more return than predicted by the manager’s beta and thus the manager has added value to the portfolio. The
greater the Jensen’s alpha, the better the manager has done. On the other hand, an alpha value of zero indicates
the manager has achieved only normal performance, meaning the manager has added nothing. If Jensen’s alpha is
negative, the manager has underperformed for the level of risk taken on.

EXAMPLE
Suppose that over the past five years a portfolio had a beta of 1.2 and an average return of 10% when the average
risk-free return was 1% and the average market return was 8%. Jensen’s alpha is calculated as follows:
JP  10%  1%  ¢¡ 1.2 q 8%  1% ¯±°  10%  1%  8.4%  0.6%

This is positive, therefore the manager of the portfolio has produced more return than expected given the
portfolio’s systematic risk, and thus has added value to the portfolio.

TREYNOR RATIO
The Treynor ratio, also called Treynor’s reward-to-volatility ratio, is a measure of the average excess return per unit
of risk. The average excess return is defined exactly as for Jensen’s alpha: average portfolio return minus the average
risk-free return, the averages computed over the evaluation period. Risk, like Jensen’s alpha, is measured by the
portfolio’s beta. The Treynor ratio for portfolio P, denoted TP, is calculated as follows:
RP  RF (17.8)
TP 
BP

The expression indicates the portfolio’s risk premium per unit of systematic risk over the evaluation period.
The higher the Treynor quantity, the better the portfolio manager did. In other words, a higher Treynor ratio is
preferred to a lower one, which provides for a ranking across portfolios. Suppose portfolio P outperforms portfolio
Q, that is, TP > TQ. We can conclude that the manager of portfolio P outperformed the manager of portfolio Q
over the evaluation period. Nonetheless, both managers, or only the manager of P, or neither manager, may have
outperformed the market over the evaluation period.

EXAMPLE
A mutual fund analyst has analyzed the risk-adjusted seven-year performance of three large-cap equity funds.
The first measure the analyst calculated was the Treynor ratio. For his calculations, the analyst gathered the
following data.

ABC Fund GHI Fund JKL Fund

Average Return 8.4% 7.5% 6.3%
Beta 1.2 1.4 0.9
Average Risk-Free Return 1% 1% 1%
8.4% – 1% 7.5% – 1% 6.3% – 1%
Treynor Ratio = 6.17 = 4.64 = 5.89
1.2 1.4 0.90

Based on the Treynor ratio, ABC Fund, with the highest Treynor ratio, outperformed JKL Fund, which in turn
outperformed GHI Fund. It is interesting to note that even though GHI Fund achieved a higher average return
compared to JKL Fund, it also had a much higher beta, and therefore underperformed JKL Fund on a risk-adjusted
basis.
Both the Jensen and Treynor measures use beta (systematic) risk in adjusting a portfolio’s returns for risk, and both
give the same conclusions regarding the performance of a portfolio relative to the market portfolio’s performance.

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When the manager outperforms the market with the Treynor ratio, TP being larger than TM, Jensen’s alpha will be
positive and thereby indicate the same result. In the same way, a negative JP implies TP is smaller than TM, showing
that the manager underperformed the market by either yardstick. However, the Treynor and Jensen measures
may differ in their rankings of different portfolios because of the manner in which they incorporate risk. Jensen’s
alpha measures deviations from the capital asset pricing model only in the return dimension, whereas the Treynor
procedure essentially divides the return deviation by beta. Thus, portfolios that differ widely in risk may conflict in
their Jensen and Treynor rankings.
Although, of the two methods, the Jensen technique is more commonly applied, many people argue that Treynor’s
technique is superior because it shows whether one manager adds more value per unit of market-related risk than
does another manager. This is a particularly important conclusion if we assume that the same result is obtained at
any level of risk.

SHARPE RATIO
The Sharpe ratio, also known as the reward-to-variability ratio, differs from the Treynor ratio only in its choice of
risk measure. Like Treynor’s quantity, the Sharpe ratio is a measure of the reward/risk ratio and the numerator is the
same as Treynor’s. However, the Sharpe ratio of a portfolio uses total risk, in the form of the portfolio’s standard
deviation of returns, as the risk measure. The calculation is shown in equation 17.9.
RP  RF (17.9)
SP 
TP

Where:
SP = Sharpe ratio
RP = the average return on the portfolio over a specified evaluation period
RF = the average risk-free return over a specified evaluation period
σP = the standard deviation of returns over a specified evaluation period
Application and interpretation of the Sharpe ratio is identical to that of the Treynor ratio: the larger the Sharpe ratio,
the better the portfolio performed. A group of portfolios can therefore be ranked by their risk-adjusted performance.

EXAMPLE
An investor calculated the Sharpe ratios of her two mutual funds over the previous four-year period. She used the
following data.

LMN Fund XYZ Fund

Average Return 9.4% 12.8%
Standard Deviation 4% 9%
Average Risk-Free Return 1% 1%
Sharpe Ratio 9.4% – 1% 12.8% – 1%
= 2.10 = 1.31
4% 9%

Based on the Sharpe ratio, LMN Fund performed better than XYZ Fund.

Like the Treynor ratio, a portfolio’s Sharpe ratio can be compared to the Sharpe ratio of the portfolio’s benchmark.
A money manager with a Sharpe ratio greater than the Sharpe ratio of the benchmark outperformed the
benchmark. A portfolio Sharpe ratio smaller than the benchmark’s signals underperformance.

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The Sharpe and Treynor ratios will give identical rankings if the portfolios evaluated are well diversified. When one
or more are poorly diversified, the rankings can be quite different because total risk (σp ) includes both systematic
risk (βp ) and unsystematic risk. The Sharpe ratio effectively penalizes poor diversification. If a portfolio is poorly
diversified, it will have a lot of unsystematic risk, thereby resulting in a large total risk relative to systematic risk. The
large total risk will result in a smaller Sharpe ratio compared to the portfolio’s Treynor ratio. On the other hand, if a
portfolio is fully diversified, its total risk will equal its systematic risk, and its Sharpe ratio will equal its Treynor ratio.
The decision to use the Treynor or Sharpe ratio in performance evaluation is based on the need for diversification
within the portfolio. The Sharpe ratio is appropriate when applied to an entire multi-managed portfolio, where the
investor is concerned about the overall diversification of the portfolio. On the other hand, if the portfolio is just one
of a few baskets, then the investor can do his or her own diversification. The investor is therefore more concerned
with the security selection ability of the manager. The Treynor and Jensen methods concentrate on security
selection, so diversification effects do not blur the results. As most professionally managed portfolios are either
sub-portfolios in a multi-manager portfolio or have a variety of clients with the majority presumably also investing
elsewhere (e.g., mutual funds), Treynor or Jensen evaluation is the correct choice.

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SUMMARY
By the end of this chapter, you should be able to:
1. Explain the steps in an effective portfolio monitoring system.
• Quarterly reviews, or even annual reviews with clients, are more appropriate for clients with a long-term view.
• Investment advisors should also ensure that their clients understand the importance of informing them of any
changes that affect their financial situation.
• Changes in lifestyle or attitude can also affect investment policy and call for a review.
• Changes in the economic environment, such as a rise or fall in market rates of return, may also call for
a review.

2. Calculate a portfolio’s return.

• If there are no cash flows, then the portfolio’s return is simply the percentage change in its market value from
the beginning of the evaluation period to the end of the evaluation period:
MVE  MVB MVE
RP   1
MVB MVB

• When there are cash flows, one way to account for cash flows is to assume that all contributions occur at the
beginning of the period and all withdrawals occur at the end of the period:
MVE  MVB  Contributions Withdrawals
RP 
MVB Contributions

• The dollar-weighted or money-weighted return measures the performance of the portfolio as experienced
by the investor. The dollar-weighted return is an internal rate of return that equates the ending value of the
portfolio to the beginning value of the portfolio and all portfolio cash flows.
• The time-weighted return eliminates the effect of portfolio cash flows and measures only the cumulative
performance of the portfolio’s investments:
TWR = [(1 + R1) × (1 + R2) × ... × (1 + RN)] –1

3. Evaluate the suitability of a benchmark.

• A good benchmark fairly evaluates the manager and provides a passive alternative. Such a benchmark has the
following basic characteristics: investable, unambiguous in composition, appropriate, attainable by manager,
specified in advance, objectively constructed, and easily measurable.

4. Compare the merits and drawbacks of different performance measurement and appraisal methods.
• Four classes of benchmarks: composite market indexes, investment style benchmarks, normal portfolios, and
Sharpe benchmarks.
« Composite market indexes: these published market indexes are designed to measure the movements of
specified markets. Not all market indexes are available in total-return form. Another incompatibility is lack
of style matching.
« Investment style benchmarks: are developed to reflect more closely the behaviour of the kinds of securities
in which the manager specializes. There is no definitive way to define a growth stock as opposed to a value
stock, but the construction of indexes requires the formulation of growth and value. Another problem with
using style indexes is the difficulty in classifying a money manager by a particular investment style.
« Normal portfolios: are specialized benchmarks that include all the securities that a manager normally
selects from. Normal portfolios more precisely define the security universe in which the manager invests.
It is neither an easy nor a costless process to construct normal portfolios.

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« Sharpe benchmarks: are created statistically using multiple-regression analysis. One drawback is that
statistical models are notoriously unstable. In addition, style indexes are often highly correlated with
each other, making it statistically difficult to separate their unique contributions. Another problem is that
analysis of past returns cannot capture the style of a manager who changes investment strategy.

5. Evaluate the performance of a portfolio.

• The purpose of performance attribution is to decompose the total performance of a portfolio into specific
components that can be associated with particular decisions made by the client and the portfolio manager.
• Risk-adjusted return measures compare the returns generated by a fund to the level of risk taken to earn those
returns. Techniques that can be used include: Jensen’s alpha, Treynor ratio, and the Sharpe ratio.

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 International Taxation 18

CONTENT AREAS

International Tax Conflicts and Double Taxation

Sources of International Tax Law and their Interrelationships

Jurisdiction to Tax

Source Country Taxation

Residence Country Taxation

LEARNING OBJECTIVES

1 | Describe double taxation and the various measures to prevent the non-declaration of assets.

2 | Describe the sources of international tax law, their interrelationships, and the various tax treaties.

3 | List and describe the various jurisdictional tax requirements as they relate to residency.

4 | Summarize source country taxation rules.

5 | Describe the various tax relief exemptions under domestic tax law.

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INTRODUCTION
This chapter is intended to provide an introduction to international taxation, and more specifically the taxation
of personal investment income from an international perspective. International tax is a bit of a misnomer as there
is no international body that has the power to tax income. Only the countries of the world and their political
subdivisions, i.e. provinces, municipalities and states, have the power to tax.
Consider the situation of Raul, who is a resident of Regina, Saskatchewan. In his investment account he owns shares
of The Walt Disney Company. Once a year the company pays a dividend to Raul and all of the other shareholders, no
matter where in the world they live. The dividend is subject to tax in both the country from which it is paid (the U.S.)
and in the country (and province) in which the shareholder, Raul, lives (Canada and Saskatchewan).
The method that each country uses to tax the dividend, and how much tax each is entitled to collect are a
complicated combination of each country’s domestic laws and the reciprocal tax treaties that each of the countries
have negotiated with the other. It is the combined effect of more than one country having the ability to tax the
same income that creates the concept of international taxation.

INTERNATIONAL TAX CONFLICTS AND DOUBLE TAXATION

Most countries tax both income and the profits generated on the sale of assets. Problems arise when transactions
occur that go across national borders as the tax laws of the two countries involved often regard the same income as
taxable in each of their countries. This double taxation (the same income being taxed in both countries) is bad for
both taxpayers and for the countries involved.
An example of double taxation would occur when rental income is generated on a rental property located in one
country, and that rental property is owned by a person who was resident in a different country. Both the country
where the rental property was located and the country where the owner lives would want to tax the rental income.
If one had a tax rate of 25% and the other had a tax rate of 50%, and there was not agreement between the two
countries, the owner would be left having to pay both taxes (double taxation) at a combined rate of 75%. This
extreme situation would be an active deterrent to much of the cross border investment that is so important to the
world economy.
Another rare anomaly can occur where both countries lose out on taxing income because each of the countries’
domestic tax rules interact so that the income might not be taxed in either country.
To help reduce the occurrences of double taxation, there are three potential solutions that countries consider:
1. Exempt income from foreign sources from home country taxation.
2. Give credit for foreign taxes paid that will reduce the amount of home country taxation.
3. Make agreements with other countries that determine how the two countries will share the right to tax specific
types of income.

EXEMPT INCOME FROM FOREIGN SOURCES FROM HOME COUNTRY

TAXATION
The idea of simply exempting income from a foreign source from taxation is by far the simplest method to resolve
the issue of double taxation. In this day of record government deficits and government debt, the idea of choosing to
not tax income that would help add to national revenue is not a popular option.
There are still a handful of countries and regions that choose to exempt all foreign income earned by individuals. The
two most noted examples are Hong Kong and Singapore. Many more countries exempt from tax the foreign source
income earned by companies that are resident. If the company’s shareholders are resident in the same country as

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the company is resident, the country will indirectly be able to tax the company’s profits by taxing the dividends
that the company pays to the resident shareholders. For shareholders that live abroad, the country is able to tax the
dividends that the company pays through a non-resident withholding tax.

EXAMPLE
One thing that makes the U.S. unique in regard to the concept of exempting foreign income earned by U.S.
companies is its hybrid approach. The U.S. will not tax the foreign income earned by U.S. companies as long as
that income remains outside of the U.S. Only when the foreign income is repatriated back to the U.S. will the U.S.
then tax this foreign source income. This has led many leading U.S. companies, including Apple, Google, Pfizer,
Microsoft, Starbucks and General Electric, to leave their foreign source income offshore.

More relevant to the individual investor is the use of holding companies and other investment structures in
countries that exempt foreign income. Used judiciously, these foreign located structures may allow investors
to “park” profits earned in foreign countries and at least defer, if not avoid, taxation in the country in which the
investor resides. Depending on the country chosen for the foreign located structure, there may not even be tax
to pay when income leaves the country, for example, in the form of a dividend. Most other countries will charge
withholding taxes on dividends, but some may have given up the right to tax dividends paid to non-residents under
a double tax treaty (commonly known as an income tax treaty).
For structures that are carefully planned and very well implemented, it may be legally possible for investors to
only be subject to taxation in their home countries for amounts that are paid out from foreign located structures
and used to fund their lifestyle. With this type of structure it may also be possible to allow income and gains to
be earned and grow on a tax-free basis in a foreign jurisdiction. Canada and many other countries do not want to
suffer from the erosion of their tax base due to this type of sophisticated planning and have enacted anti-avoidance
legislation to try to combat these structures.

GIVE CREDIT FOR FOREIGN TAXES PAID

The second option to eliminate the problem of double taxation would be to give credit to home country residents
for foreign taxes paid on income that will also be taxable in the home country. This strategy has been adopted by
most larger countries, including Canada and the U.S. While the U.S. does not tax foreign profits that are left abroad,
Canada does tax foreign income earned by Canadian companies. Rather than miss the chance to tax these foreign
generated profits, Canada taxes the foreign income, and then provides a credit for the foreign taxes paid to the
country in which the profits were generated. In this way the company is in effect paying part of the taxes on their
foreign profits to the foreign country in which the profits were generated and part of the taxes required to Canada.

MAKE AGREEMENTS WITH OTHER COUNTRIES THAT DETERMINE HOW THE TWO
COUNTRIES WILL SHARE THE RIGHT TO TAX SPECIFIC TYPES OF INCOME
The ability to make different rules for different types of income is the one main reason why income tax treaties have
emerged. Since the late 1800’s, countries have been negotiating treaties that set out how each country will share
the right between themselves to tax different types of income. If the two countries can agree on how a specific type
of income is taxed then the challenge of whether to exempt or give a credit related to a specific type of income does
not arise. When income is generated in a foreign country that is subject to tax in that foreign country, tax treaties
will often limit the foreign country’s ability to tax that income to a certain level of withholding tax. This is the
most frequently used method for investment income (dividends, interest, and royalties), where withholding tax is
generally the only method of taxation allowed by the income tax treaty for the foreign country in which the income
arises.

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ANTI-AVOIDANCE MEASURES AND MEASURE TO PREVENT

NON-DECLARATION OF ASSETS
Many countries, including Canada and the U.S., have adopted measures to try to prevent and to collect tax revenue
from both legal and illegal attempts to structure international transactions that would locate profits as much as
possible in low tax countries. This includes an active battle against taxpayers who choose to not declare assets
held abroad and the income that these assets generate. International cooperation has also been obtained in recent
years with Switzerland, one of the most sensitive countries in the world when it came to the preservation of client
confidentiality and a previously favoured country for taxpayers who chose not to declare their international income.

SOURCES OF INTERNATIONAL TAX LAW AND THEIR

INTERRELATIONSHIPS
There are several sources that work together to create the taxation environment for any taxpayer that earns any
type of income in a country other than the one in which they are resident. The three main sources of tax law are:
1. Domestic tax law in the country in which the income is generated.
2. Domestic tax law in the country in which the receiver of the income is resident.
3. Any income tax treaty that is in place between the two countries involved.

DOMESTIC TAX LAW

Domestic tax law is the foundation upon which the complex interactions that make up international tax law
operates. It is domestic law that specifies when and how a tax liability arises on any domestic or cross border
transactions. In particular, it identifies relevant factors that bring a transaction within the scope of the ability of
domestic tax authorities to levy taxes. The authority to tax in Canada is based on the Constitution Act of 1867.
Interestingly, while this same act provides the authority for provinces to levy taxes, the provinces are limited to only
direct taxation within its own borders. This is the reason that only federal taxation rules are considered when looking
at international tax from a Canadian perspective.
In the U.S., it is the Constitution that grants Congress the powers to “lay and collect taxes, duties, imposts and
excises, to pay the debts and provide for the common defense and general welfare of the United States.” The
Constitution defines Congress as the Senate and House of Representatives, so these two elected bodies have to
work together on matters of both domestic and international taxation.

INTERNATIONAL TAX TREATIES

International tax treaties are always concluded on a bilateral basis – in other words between two individual
countries – to provide for the integration of their two tax systems. Countries often have standard patterns to their
tax treaties and common policy goals that they negotiate to achieve, and these can both be seen in looking at a
number of tax treaties.

EXAMPLE
In the 1960s, the Organisation for Economic Co-operation and Development (OECD) took on the task of
producing a model international tax treaty to be used by its member countries. The OECD also produced a
Commentary that supported the model treaty. Most international tax treaties negotiated since the 1960s follow
the OECD model treaty.

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There are competing models for the development of international tax treaties. The U.S. has produced a separate
model international tax treaty on which it negotiates its own tax treaties. As well, a United Nations (UN) model
treaty has been developed that is favoured by a number of developing countries. While each of these are similar
to the OECD model treaty, the differences favour the countries that use these models as their standard for
international tax treaty negotiations.
This background to tax treaties matters for a number of reasons. First, it explains that tax treaties are, almost
exclusively, bilateral in nature. This means that they do not work so well in situations involving three or more
countries. Secondly, the main purpose of international tax treaties is to remove double taxation between two
countries, and as such are often also referred to as “double tax treaties”.
Even so, the main beneficiaries of double tax treaties are the taxpayers and not the tax authorities because treaties
effectively limit the amount of tax that each country involved will be able to collect.
The third reason is that many countries, including Canada and the U.S., have implemented many international
tax treaties over an extended number of years. This makes the countries and the international tax treaties rather
inflexible. It also limits the ability of countries with international tax treaties to change any domestic tax legislation
in a way that would be inconsistent with the international tax treaties it has negotiated. It also takes a number of
years to negotiate a single international tax treaty. Commercially, it would be very difficult and costly to terminate
an international tax treaty.
Also because international tax treaties have been negotiated over many years, over time a number of irreconcilable
differences between treaties worldwide have occurred, leading to the potential for tax treaty planning and
potentially tax treaty abuse.

DO TAX TREATIES CREATE OR RAISE TAX LIABILITIES?

It is very important to note that international tax treaties do not create any tax liabilities where none exist under
domestic tax law. International tax treaties can only reduce or eliminate these domestic taxes. For example, the
double tax treaty between Canada and the U.S. provides for a 10% withholding tax on interest income. Canada can
only levy this 10% tax if its domestic laws permit this taxation of non-residents earning interest income in Canada.
Canada has changed its domestic tax law in recent years to specifically exempt certain types of interest income
earned by non-residents of Canada from Canadian taxation.
So even though the double tax treaty with the U.S. permits Canada to charge a 10% withholding on interest, Canada
cannot use this provision to create a tax, as Canada’s domestic laws specifically exempt this type of income from
Canadian taxation. In effect, this means that the rate of withholding tax specified in international tax treaties are
the maximum possible tax rate, and not the absolute tax rates.

RELATIONSHIP OF TAX TREATIES TO DOMESTIC TAX LAW

Treaties are governed by international law rather than by domestic laws. The general rule under the Convention is
that treaty provisions override those domestic tax laws and that the countries involved must act in good faith to
give effect to the treaty provisions. In Canada, the U.S. and many other common law countries, international tax
treaty law has the same status as domestic tax law. Using the general principle that a later law overrides an earlier
law, treaty override is usually possible. However, Canada has specifically built in protection for its international tax
treaties into its domestic tax law.

INTERPRETATION OF TAX TREATIES

This is a subject that could take up a book in itself and there are a number of experts, mostly employed in
accounting and legal firms, that interpret international tax treaties. A few points should be noted.

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UNDEFINED TERMS REFER BACK TO DOMESTIC LAW

Some terms are defined in the OECD model treaty. For example the terms “interest” and “dividends” are given fairly
extensive definitions in tax treaties. But many other terms remained undefined. Many international tax treaties
provide that undefined terms will then have the meaning they have in the domestic law of the country involved
in the treaty. A challenge occurs for taxpayers relying on the treaty when the two countries involved define the
same term in two different ways. This can have the result of double taxation because each country regards itself as
entitled to tax.

SPECIAL TREATY MEANING

Sometimes the intended purpose of the treaty will make it clear that one has to depart from the ordinary meaning
of the treaty’s words where the context requires this. The meaning in such cases would be different from the
meaning of the term in the domestic tax law of either country and would have a special “treaty meaning”. A good
example of this is the term “beneficial owner”. As will be described in more detail below, the concept of beneficial
ownership is used in many tax treaties in relation to withholding tax in the country in which the income originated.
The policy is to restrict relief that is granted by the international tax treaty from withholding tax on the investment
income to only the true economic owner of the income. The intention of this is to prevent the insertion of a shell
company in a favourable jurisdiction just to benefit from a treaty that the favourable jurisdiction is party to.

JURISDICTION TO TAX
The question of whether a taxpayer is resident in any given country is clearly central to the person’s tax affairs
and will always be a matter of domestic law. In Canada, the Income Tax Act (ITA) under section 2, explains that an
income tax shall be paid on the taxable income for each taxation year of every person resident in Canada at any
time in the year. The ITA also explains the tax payable by non-resident persons.

RESIDENCE OF PERSONS AND DOMICILE

Residence is the most commonly used connecting factor to establish taxing jurisdiction. Different countries have
a variety of domestic law tests of what constitutes sufficient presence to make an individual resident for tax
purposes. For example, Canada has a long list of rules that are used to determine if a person is a resident. Significant
residential ties that include a home or spouse in Canada are key for the determination of Canadian residency.
Secondary residential ties such as social ties to Canada and Canadian government issued identification are also
considered. Special rules exist for both immigrants and emigrants. Canada also has a special 183 day rule for people
that are otherwise non-residents of Canada that stay for extended periods in the country.
Because national tests of residence can vary widely between countries, it can easily happen that two or more
countries each claim the right to tax a person on the basis of residency at the same time.

EXAMPLE
Alfredo is a Spanish businessman. He lives in Spain for the majority of the year conducting his business. But
he spends considerable time, amounting to almost 4 months each year in Canada living with his common-law
spouse with whom he has two children. While in Canada he is able to continue to operate his business remotely
using e-mail and other electronic communication means. Both Spain and Canada will treat Alfredo as resident
and want to tax him on his worldwide income. Alfredo will have to rely on the double tax treaty between Spain
and Canada to try to resolve the issue of double taxation.

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In common law countries, domicile is distinguished from residence to mean a more long-term link or association
with a country. Broadly, under common law, domicile is the country that you regard as your home. So while it is
possible to be a tax-resident under the laws of more than one country at a time, a person can only ever have one
domicile at a time.
Many U.S. states use the concept of domicile to determine whether a person is primarily subject to tax in the
state. An example where this would frequently occur would be a person who lives in New Jersey, but crosses into
Manhattan every day to work in New York City. The person would be domiciled in New Jersey and be treated by
New York State and New York City as a non-resident for tax purposes.

RESIDUAL RIGHTS OF TAXATION FOR RESIDENCE COUNTRY

Given that the country in which income is generated will always have the primary right of taxation, it is the decision
of the country of residence as to whether it will exempt the foreign source income from home country taxation,
or decide to give tax relief in the form of tax credit on the income derived from foreign sources. The country of
residence can do these under domestic tax law or under the provisions of income tax treaties.

NATIONALITY
There are very few countries that impose a tax on their citizens simply because they hold or have a right to acquire a
passport of the country — the main exception being the U.S. Anyone who is a U.S. national (or a green card holder)
automatically becomes a U.S. taxpayer, whether or not they have ever set foot on American soil in their lives or hold
any assets in the U.S.
This causes double taxation issues for every U.S. citizen who lives outside of the U.S. The problem is largely resolved
by U.S. double tax treaties, the overall effect of which is that the U.S. gives credit for the tax already paid by U.S.
citizens who are residents of the other countries. Where the U.S. tax is higher than that of the country in which the
U.S. citizen is living, this will result in a U.S. tax balance owing. This has caused a number of U.S. citizens and green
card holders to give up their U.S. nationality. This is a very complex process and can result in additional taxes to be
paid, especially for high and ultra-high net-worth individuals. Specialist U.S. tax advice needs to be sought as there
can be longer term impacts from this decision.

RECONCILING CONFLICTS OF RESIDENCE FOR INDIVIDUALS

As noted above, it is very possible to be considered resident under the domestic tax laws of more than one country.
This would mean that the person would be taxable on their worldwide income in more than one country and
potentially subject to double taxation. If there was no income tax treaty between the two countries involved, then
the two countries would have to resolve the issue under their own separate national taxation systems. Neither
country can prevent the other from claiming the right to tax. What either country can do is either exempt foreign
income from tax in their own country or give credit for taxes paid to the foreign country.
Where there is an income tax treaty, the issue of residency conflict can be removed. Article 4(2) of the OECD model,
which has been adopted as the starting point for Canadian tax treaties, provides as follows for cases of conflicting
residence claims under the national laws of both countries:
Where by reason of the provisions of paragraph 1 an individual is resident of both Contracting States, then his status
shall be determined as follows:
a. he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he
has a permanent home available to him in both States, he shall be deemed to be a resident only of the State
with which his personal and economic relations are closer (centre of vital interests);
b. if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent
home available to him in either State, he shall be deemed to be a resident only of the State in which he has an
habitual abode;

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c. if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the
State of which he is a national;
d. if he is a national of both States or of neither of them, the competent authorities of the Contracting States
shall settle the question by mutual agreement.

The provisions are largely self-explanatory. The question of where an individual has his “centre of vital interests” is
more subjective. The OECD Commentary at paragraph 15 describes it as follows:
Thus, regard will be had to his family and social relations, his occupations, his political, cultural or other activities,
his place of business, the place from which he administers his property, etc.
The Canada-U.S. international tax treaty follows this wording very closely, only substituting in the word “citizen” for
the word “national” in items c) and d).
Where the question has to be determined by mutual agreement between Canada and the U.S., there is a tribunal
process in place that sorts out the most complex situations. This tribunal has the authority to issue decisions that
are binding on both countries.

RESIDENCE OF NON-NATURAL PERSONS

In the case of a corporation, the question of residence is purely a matter of domestic taxation law. A list of potential
tests follows to determine residency, and it is possible to be determined resident in more than one country at a
time.

INCORPORATION
One connecting factor to establish the tax residence of companies that most countries have in common is the law
under which a company is registered. This is in many ways the corporate equivalent of nationality. Just because a
company happens to be registered under the law of a particular country, there is no obvious reason why it should
owe that country much in the way of economic allegiance. Its management may be based elsewhere, so could its
day-to-day business. An example of this would be Eaton, a maker of components and electrical equipment, which
has moved its place of incorporation to Ireland. At the time of making the change the company announced that the
change would provide tax benefits of about $160 million a year.

MANAGEMENT
To stop companies simply choosing to incorporate under the law of smaller lower tax countries, but maintain their
management in high tax countries, most countries also apply an alternative test for tax residence that is based on
the place from which the business of the company is actually conducted.

COMMON LAW: CENTRAL MANAGEMENT AND CONTROL

The majority of common law jurisdictions, including Canada, have adopted the test of central management and
control originally derived from an English case, De Beers Consolidated Mines Ltd v. Howe (Surveyor of Taxes) that
dates back to 1906. De Beers was a gold and diamond mining company incorporated in South Africa, where the
company held its head office and main trading operations. But the majority of its directors and life governors lived
in England.
Lord Loreburn, one of the judges in the case, came up with the following test that was widely quoted and adopted in
common law countries: “a company resides, for purposes of income tax, where its real business is carried on. I regard
that as the true rule; and the real business is carried on where the central management and control actually abides.”

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ACTIVITIES AND SOURCES

The other basis apart from residence on which countries assess tax is the source of the income or gains being
generated. Even if the owner is not resident in the country in which income or gains are generated, that country
often would want to tax the income or gains.
For example, a resident of Canada may own a condominium in Arizona (in the U.S.) that is rented out for short
periods during the year. Canada will assume the right the tax the Canadian resident on their worldwide income
based on residence, and this will include the net rental income, after allowable deductions are taken. At the same
time, the U.S. will regard itself as entitled to tax the Canadian resident on the rental income that is generated from
the U.S. located source. The U.S. will tax the rental income using its own domestic tax law rules, which do differ in
significant ways from the Canadian tax rules for this same type of income.
What is clear from this example is that there is scope for two bases of jurisdiction: source and residence. These two
bases collide and produce the problem of double taxation that is the focus of this section.

GROSS OR NET TAXATION – WITHHOLDING TAX

In practice, in the absence of a tax treaty, it will always be the source country that has the primary rights of taxation.
Because the source of income is located within its jurisdiction, it can get to the money first. It then has the choice of
whether to tax on a gross basis or to look more carefully at the situation of the taxpayer and take into account his or
her costs of earning the income by taxing on a net basis by allowing the appropriate deductions, as described above
with the rental income.
Not surprisingly, many countries that are the source of the income find it in general more convenient to simply
tax the gross amount of the income generated in their country. Particularly in the context of private investment
income, they frequently withhold taxes on the gross amount of the income. The main exception to this is the
holding of real estate, where most countries will allow deductions for the costs of maintenance and to some extent
the cost of acquisition.

SOURCE COUNTRY TAXATION

This section is concerned with the allocation of the right to tax by the country in which income is derived (sourced).
To get a better overview, the respective taxation rights of source and residence countries are summarized in general
below:
In the absence of a treaty:
• Source and residence countries may levy whatever taxes they wish under their domestic tax laws.
• Attempts to enforce tax compliance across the border to the other country will require the cooperation of the
other country.

Under income tax treaties:

• Exclusive taxing rights for the country of residence
• Capital gains not related to immovable property (i.e. real estate)
• Royalties (some income tax treaties may treat this item differently)
• Any type of income not covered by a specific provision of an income tax treaty
• Limited tax rights for the country in which the income is sourced
• Interest income (in the form of withholding tax)
• Dividend income (in the form of withholding tax)

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 CHAPTER 18 | INTERNATIONAL TAXATION 18 • 11

• Full taxation rights for the country in which the income is sourced
• Income and capital gains from immovable property in the source country
INCOME FROM IMMOVABLE PROPERTY
The OECD model treaty provides that income from immovable property may be taxed in the country in which the
property is located. This is the most extensive type of taxation right given to the country in which income is sourced
under the OECD model treaty. The source country has the full right to tax and not merely a more limited right to
levy a withholding tax, as in relation to other investment income such as with interest and dividends.
Immovable property generally uses the meaning under the domestic law of the country in which the property is
located. Some exceptions include dividends from property companies and real estate investment trusts (REITS).
REITS are treated differently by the OECD model treaty. The OECD model treaty’s commentary makes it clear
that unless there are specific provisions in the treaty, distributions are to be taxed as dividends that are subject to
withholding taxes, and not taxed as immovable property. The Canada-U.S. income tax treaty uses this withholding
tax treatment and a limit of 15% withholding tax on the dividends paid across the border.
On the sale of immovable property, the rules used to determine the taxable amount of a gain for the tax purposes
of the country in which the property is located would apply when the seller is resident in another country. This
would allow for only the net amount of the gain to be taxed and not the entire proceeds.

INVESTMENTS THAT GENERATE DIVIDENDS, INTEREST AND ROYALTIES

This section covers the classic forms of passive investment income: dividends, interest and royalties, that make
up the most significant items of passive investment income. The issue of importance is how the country in which
these income items are sourced uses their domestic tax law to tax these income streams and the limits imposed by
income tax treaties that are in place.
The starting point for taxation is always domestic tax law. Some source countries may choose not to tax these
payments at all. For example, the U.K., Australia and Singapore under their domestic tax law do not levy any
withholding taxes on dividends. Canada and the U.S. under their domestic tax law exclude most forms of interest
income from withholding taxes for non-resident recipients of this income. Therefore all the provisions in these
countries’ tax treaties limiting their rights to withhold taxes on dividends or interest (as appropriate) may be
completely irrelevant. The example of Canadian interest income was discussed earlier in the text. But by and large
these examples are exceptions, as most countries try to tax as much as the income that is sourced domestically
as possible.

DIVIDENDS
Dividends are defined in many of Canada’s income tax treaties, and in the OECD treaty in Article 10(3). These
treaties effectively define dividends as income from shares and have the key attribute of being payments which
represent a participation in the profits of the paying entity.
Most income tax treaties provide that dividends can be taxed in both countries. That is the country from which the
dividend income was paid and also the country of residence of the recipient of the dividend income.
It is pretty much impossible to make non-resident shareholders fill out tax returns and pay taxes annually on the
dividend income that they receive. Instead, almost all source countries require companies to pay their foreign
shareholders the net amount of dividends only after a flat withholding tax has been deducted and remitted to the
tax authorities of the country in which the dividend arose.
The OECD model treaty makes it clear that the primary taxing right in relation to dividends lies with the country of
residence. The article also gives the country in which the dividend arose a more limited right to tax the dividend so
long as the recipient is also the beneficial owner of the dividend.

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In general the requirement for beneficial ownership is to stop the practice of routing payments through nominee
companies in countries that have advantageous double tax treaties, and which are obligated to then pay the
dividend on to a person (likely the beneficial owner) in a third country.
The requirement for beneficial ownership also applies to interest and royalties. If the recipient is not the beneficial
owner then the source state is not limited by the treaty as to how much withholding tax it may apply.
Consider the example of a resident of Canada who owns dividend paying shares of a Japanese company. But instead
of owning these shares through a Canadian brokerage account, the shares are owned through a nominee company
in another country with which Japan has a double tax treaty that is more favourable than the Canada-Japan income
tax treaty rate of 15%. It is this type of behaviour that the OECD model treaty and the concept of beneficial
ownership is trying to eliminate.

INTEREST
The OECD model treaty that discusses interest follows the same pattern as that of dividend income described
above. Just like dividends, interest may be taxed in both the country in which it originates and also in the country in
which the recipient is resident.
If the recipient is the beneficial owner, the withholding tax deducted at source is limited in the OECD model treaty
to 10%. But as in the case of dividends, this percentage is only a guideline in the model treaty. In fact, withholding
rates on interest of up to 15% are not uncommon. The Canada – Turkey income tax treaty is just such as case, with
the withholding tax charged not exceeding 15% of the gross amount of the interest paid. Often interest paid from a
source in one country to the government of another country is exempt from withholding tax in the country of origin
of the interest payment.

ROYALTIES
Article 12 of the OECD income tax model treaty gives exclusive taxation rights to the state of residence of the
beneficial owner of the royalty. But many double tax treaties do not follow the OECD model treaty as many do
permit withholding taxes on royalties to be charged by the country in which the royalties arise. As an example,
the Canada – U.S. income tax treaty does permit both countries to tax royalty payments. The Canada – U.S. treaty
states that the withholding tax in the country that was the source of the royalty is limited to 10%.
Royalties are defined by treaties and often contain a long list of intellectual property assets for which copyrights,
patents and trademarks apply.
As with dividends and interest, there is a requirement that the recipient of the royalty income is its beneficial owner
to prevent treaty shopping that could occur if a nominee was inserted in a favourable treaty country, but with an
obligation to pay forward the royalty to the ultimate beneficial owner resident in a third country.

CAPITAL GAINS
Individual countries have widely varying tax rules in relation to their domestic taxation of capital gains. In some
countries, capital gains are taxed in the same way as ordinary income. In others capital gains are given special
treatment. In yet others, gains may not be taxed at all. Canada gives special treatment to capital gains, requiring
that only 50% of the gains be taxable at the taxpayer’s normal rate of tax. The U.S. has a more complex set of
requirements for the treatment of capital gains. Short term capital gains (defined as the gain that results from the
disposition of property held for less than one year) are taxed as ordinary income. But long term capital gains (those
gains that result from the disposition of property held for at least one year) are taxed at special lower tax rates.
The OECD model does not try to deal specifically with this variety of domestic tax approaches. Instead the model
treaty declares that in most situations, including the sale of portfolio investments, capital gains are taxable
exclusively in the taxpayer’s country of residence. There are often exceptions to this general rule for disposition
of real property (real estate), where it is common for both treaty countries to be able to tax the real property
disposition.

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Article 13 of the OECD Model treaty refers to capital gains derived from the “alienation of property”. Alienation is
a very wide concept that includes ordinary asset disposals (by sale or gift), and also situations such as exchanges of
assets and the disposition of assets upon death. Although not all countries levy taxes in all of these situations, the
meaning of the term alienation is wide enough to give countries the right to tax under the treaty if their domestic
tax law provides for the ability to levy a tax in the situation.
The taxation of the sale of real estate according to income tax treaties can be shared by both the country in which
the alienated real estate is located and the country in which the beneficial owner is a resident. This is logical given
the very close connection between the gain on the property and the country in which the real estate is located.
Canada has a special provision built into many of its treaties that provides Canada (and its treaty partner) the
continuing right to tax where an individual changes their country of residence to the other country that has signed
the treaty. The Canada-U.S. income tax treaty permits the country from which the taxpayer departed to tax the
gains on the disposition of property if the disposition happens in the first 10 years after ceasing to be a resident of
the original country. This ability to tax non-residents on the disposition of property is limited though to property (or
in certain cases untaxed substituted property) that was owned by the taxpayer at the time that they ceased to be a
resident for tax purposes of the first country.
This special treaty rule is in addition to the deemed disposition rules that Canada applies when a taxpayer ceases
to be a resident of Canada. Many of Canada’s international tax treaties allow emigrating residents to elect to be
treated in their new country as if they had sold and reacquired their assets on the date they change residence. This
step up in cost base in the new country of residence avoids the potential double capital gains taxation that would
result from the combination of Canada’s deemed disposition rules and an actual disposition at a later date while
resident in the new country.
This bump up in cost base also applies to the deemed disposition of a principal residence located in Canada for a
taxpayer moving to the U.S. Situations where this would be very important would be when a person moves from
Canada to the U.S., but only is able to close the sale on their principal residence after they had departed from
Canada. Without this provision in the tax treaty, the entire gain from the time the principal residence was purchased
in Canada to the date of the sale would be taxable in the U.S., even if the person was a resident of the U.S. for only a
few days.

RESIDENCE COUNTRY TAXATION

After examining the taxation rights of the country in which income originates, looking at the taxation rights of the
country in which the recipient of the income is resident is more straight forward. The right of the residence country
to impose taxes is not excluded by income tax treaties. Income tax treaties on income and gains instead allocate the
home country rights to taxation between it and the country in which income arises.
The practical effect of treaties is that the country in which the income arises often has the first right of taxation,
with the country in which the recipient is resident being left to relieve the effect of the source country taxation for
the taxpayer. As noted above, there are two methods that the country of residence can use to reduce the potential
of double taxation. These two methods are exempting the foreign source income from taxation or giving credit
to resident taxpayers for taxes paid to the country from which the income was derived. Many countries, including
Canada and the U.S. prefer to offer credit, as it preserves the overall tax base better than providing exemptions from
domestic tax for foreign source income.

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TAX RELIEF UNDER DOMESTIC TAX LAW – RELIEF BY TAX CREDIT

When the country of residence chooses to provide relief by tax credit, foreign income is taxable. Foreign income is
taxable due to the worldwide income reporting requirements. Foreign taxes paid are then creditable against the tax
due in the country of residence on the worldwide income. Effectively this results in the taxpayer ending up paying
the higher of the source country and the residence country tax on all income.
In the case of investment income, the tax credit will be the amount of withholding tax taken on the dividends,
interest or royalties. The country of residence will reduce the tax liability of its residents by the withholding tax paid
to the foreign country on the investment income.

EXAMPLE
Jonathan earned the Canadian dollar equivalent of $1,000 of dividends from his equity holdings of a company
located in Germany. According to the Canada – Germany income tax treaty, these dividends would be subject
to a maximum withholding tax rate of 15%. This would mean that over the course of the year Jonathan only
received the cash equivalent of $850 from the German company, with the other $150 being remitted to the
German tax authorities.
When Jonathan prepares his Canadian income tax return, he would have to report the full $1,000 in foreign
source dividend income on his tax return and this would be subject to Canadian tax at his marginal tax rate. As
the dividend is from a non-Canadian source it would not be eligible for the beneficial Canadian tax treatment
that involves the dividend gross up and dividend tax credit. With his marginal tax rate of 45%, Jonathan would
be subject to $450 in Canadian income taxes. But as $150 has already been paid to Germany, Canada provides a
foreign tax credit for this amount.
The net result is that Jonathan owes only $300 in taxes to Canada on the German source dividends. His total
tax bill is still $450 which is the gross amount of the foreign source dividend multiplied by his marginal tax rate.
The effect of the income tax treaty and the withholding tax is to allocate the taxes Jonathan would pay anyways
between the source country and his country of residence.

Complicating the calculation of foreign tax credits are the methods that many countries use to place limits on the
amount of credit available. Canada calculates foreign tax credits on a per country basis. This would mean that if
Jonathan had investments in several foreign jurisdictions, that each had different rates of withholdings, he would
be limited in the amount of credit that he could apply from the higher tax rate countries, meaning some of the
foreign taxes paid might not be usable to reduce his Canadian taxes. If instead Canada put all foreign taxes paid
into one foreign pool, the high tax rate and low tax rates could average out allowing greater use of the credit, but
unfortunately this is not the case.
The U.S. instead allows the foreign withholding taxes on all passive income that includes interest and dividends to
be accumulated in one basket for all countries in the world. This provides an advantage compared to Canada as high
tax rates and low tax rate can be averaged out to potentially claim a larger foreign tax credit. The U.S. has a number
of baskets for different types of income which includes the passive income basket. These baskets ensure that foreign
taxes paid on specific types of income have to be matched to that type of income, from any country, which may
limit the amount of foreign taxes claimed.
Canada also uses a basket approach to a small extent. Canada separates foreign taxes paid on business income from
foreign taxes paid on all other types of income. This ensures that foreign taxes paid on business income cannot be
used to reduce overall taxes on all other types of income, and vice versa.
Occasionally more foreign taxes are paid than are available to use as a credit to reduce the amount of domestic
taxes payable. For most countries these excess foreign taxes paid are lost and not creditable in the future. A few
countries do however allow excess foreign taxes paid to be carried forward to potentially be used in the future.
For example, the U.S. allows foreign taxes paid to be carried forward for up to 10 years. Often this will happen
when a U.S. citizen moves to a higher tax country such as Canada. A U.S. citizen always has to file an annual tax

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 CHAPTER 18 | INTERNATIONAL TAXATION 18 • 15

return reporting their worldwide income, and they would have to file a Canadian income tax return reporting their
worldwide income. As Canadian income taxes are generally higher than U.S. income taxes, the excess not needed to
reduce any U.S. tax liability will be carried forward to be available for future use on the U.S. tax return.
Canada also has the ability to carry forward foreign taxes paid that are in excess of the amount used to reduce taxes
payable in Canada. But this carry forward is only available for the business income basket. Any excess foreign taxes
paid that are not creditable for the year that they are paid that relate to other income, such as investment income,
on the Canadian tax return simply expire and cannot be used in a future year.

TAX RELIEF UNDER DOMESTIC TAX LAW – RELIEF BY DEDUCTION

In the deduction method, foreign income is taxable in the resident state but taxes paid in the source country are
allowed as a tax deductible expense. Canada does have one special situation where tax relief for foreign taxes paid
is achieved to some extent by a deduction. The deduction is permitted under section 20 (11/12) of the Canadian
ITA. This section allows for withholding tax taken by a foreign country that is in excess of 15% to be used as a tax
deduction against the taxpayer’s income. While this does provide some tax relief on the excess tax over 15% taken
by the foreign country, the relief is only partial as it is scaled down by the taxpayer’s tax rate.

U.S. TREATIES – SAVING CLAUSES

U.S. treaties have a rare problem to deal with in their double tax relief articles. The U.S. is one of the few countries in
the world that reserves the right, through a “saving clause” (Article 1(4) of the U.S. Model Treaty) to charge full U.S.
taxes on its residents and on individuals who are, or have been, U.S. citizens.
This means that a U.S. citizen outside of the U.S. who lives in a foreign country may find that they are subject to
full residence-based taxation in both the U.S. and the foreign country. The U.S. wishes to ensure that its citizens pay
the same amount of tax worldwide as if they were just resident in the U.S. Normally the foreign country would give
credit to its residents for taxes paid to an outside country, but it would not be amenable to concede a very large tax
credit to its U.S. citizen resident simply because of the U.S. insistence to tax its citizens as if they were still resident
in the U.S. Often the foreign country of residence will limit the amount of U.S. tax it will credit to the amount of tax
the U.S. would have charged to a non-resident who was not a U.S. citizen on just the amount of U.S. source income.
Without a saving clause this would leave U.S. taxpayers in a large double tax predicament, having to pay full tax in
their country of residence less a smaller foreign tax credit plus full U.S. tax. The saving clause provides an additional
tax credit on the U.S. tax return for the amount of tax paid by the U.S. citizen to the foreign country in which they
are resident. The effect of these complex steps is to bring the U.S. citizen’s global tax bill back down to what it would
have been if they had been only a U.S. tax resident.

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SUMMARY
By the end of this chapter, you will be able to:
1. Describe double taxation and the various measures to prevent the non-declaration of assets.
• Double taxation involves the same income being taxed in two countries. To help reduce the occurrences of
double taxation, there are three potential solutions that countries consider: exempt income from foreign
sources from home country taxation, give credit for foreign taxes paid that will reduce the amount of home
country taxation, or make agreements with other countries that determine how the two countries will share
the right to tax specific types of income.

2. Describe the sources of international tax law, their interrelationships, and the various tax treaties.
• The three main sources of tax law are: domestic tax law in the country in which the income is generated,
domestic tax law in the country in which the receiver of the income is resident, and any income tax treaty
that is in place between the two countries involved.

3. List and describe the various jurisdictional tax requirements as they relate to residency.
• Residence is the most commonly used connecting factor to establish taxing jurisdiction. Different countries
have a variety of domestic law tests of what constitutes sufficient presence to make an individual resident for
tax purposes.

4. Summarize source country taxation rules.

• Source country taxation is concerned with the allocation of the right to tax by the country in which income
is derived (sourced). In the absence of a treaty: source and residence countries may levy whatever taxes
they wish under their domestic tax laws. Attempts to enforce tax compliance across the border to the other
country will require the cooperation of the other country.

5. Describe the various tax relief exemptions under domestic tax law.
• Tax relief under domestic tax law by credit. When the country of residence chooses to provide relief by
tax credit, foreign income is taxable. Foreign income is taxable due to the worldwide income reporting
requirements. Foreign taxes paid are then creditable against the tax due in the country of residence on the
worldwide income.
• Tax relief under domestic tax law by deduction. In the deduction method, foreign income is taxable in the
resident state but taxes paid in the source country are allowed as a tax deductible expense.

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Glossary
Adjusted Cost Base (ACB) American Depositary Share (ADS)
A
A fund or trust’s new average unit A security issued by a U.S. depositary
cost after the original cost of the (usually a trust company), and traded
Absolute advantage units is reduced by the amount of the on a U.S. exchange, representing
A barrier to entry that helps deter distribution. ownership interest in the securities of
companies from entering an industry. a foreign company. See also American
Age approach Depositary Receipt (ADR).
Absolute valuation model An approach to strategic asset
A valuation model that outputs a allocation that recommends an Amortization schedule
point estimate or precise value for the allocation to debt securities equal to The regular or semi-regular repayment
intrinsic value of a stock, based on a the client’s age. of a debt security’s principal over the
set of forecast company fundamentals. life of the security. See also Principal.
Allocation return
Accrued interest The return on the portfolio based on Ascending triangle
Interest on a debt security that has the decision to shift the portfolio’s A triangle with a horizontal resistance
accrued since the last coupon payment weights from the strategic asset line and a positively sloped trend
date, but has not yet been paid. allocation. line acting as support. See also
Descending triangle, Symmetrical
Active investment strategy Alternative investments triangle, and Triangle.
An investment strategy that uses Asset classes that are different from
expectations about individual the traditional three broad asset Asset allocation
securities and the overall investment classes of equities, bonds and cash. The process used to determine
environment to build a portfolio the appropriate proportions of an
that will take advantage of those Alternative Trading System (ATS) investor’s portfolio to invest in
expectations. See also Bottom-up An off-exchange private electronic different asset classes. See also Asset
approach, and Top-down approach. network that discretely and directly class, Strategic asset allocation, and
matches buyers and sellers using Tactical asset allocation.
Active listening a computer program. There are no
Assessing the significance of a message middlemen. Large orders can be Asset class
by listening for the core meaning, executed with little or no market A specific category of assets or
and relate it to other information impact. investments, such as cash, stocks,
about the client before deciding on bonds, real estate and international
its significance and an appropriate Alpha securities. Assets within the same class
response. The degree to which a fund’s manager generally exhibit similar characteristics
has added value relative to the fund’s and, most importantly, behave in
Actively managed fund benchmark index, given the portfolio’s a somewhat similar manner in the
A managed product whose manager systematic risk (as measured by its marketplace.
makes investment decisions based on beta) relative to the index. See also
his or her outlook for the markets and Beta and Risk-adjusted return. Asset location
securities in which he or she invests. The allocation of assets between
See also Passively managed fund. American Depositary Receipt (ADR) registered and non-registered
A certificate representing ownership accounts. See also Non-registered
Ad hoc approach of the securities of a foreign company. account and Registered account.
An approach to strategic asset See also American Depositary Share
allocation that is based on an IA’s (ADS).
opinion or gut feeling.

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G•2 INVESTMENT MANAGEMENT TECHNIQUES

Asset-backed security (ABS) Barrier to entry Benchmark risk

A debt security backed by a pool of An obstacle that prevents a company The variation in portfolio returns
financial assets, including mortgages from profitably producing a product or by holding securities outside the
(in which case they are known as service. See also Absolute advantage, benchmark universe. Any performance
mortgage-backed securities), credit Product differentiation, and deviation will not come from security
card receivables, automobile loans, Economies of scale. selection or market timing within the
or other debt obligations. See also universe, but from style shifts.
Mortgage-backed security. Basic earnings per share
A company’s earnings per share based Beta
Attending only on the weighted average number A measure of the relative or systematic
Conveying to clients that the advisor of common shares outstanding. See risk of a security or portfolio of
respects their needs and are interested also Earnings per share and Fully securities compared to the overall
in helping them with their individual diluted earnings per share. market. Security betas are usually
objectives. estimated using simple regression
Behavioural finance analysis.
Attitudinal question The study of how human psychology
A question that seeks an investor’s affects an individual’s investment Bias
attitude about one or more aspects of decision-making process. See also A preference or an inclination
investing. Biased expectations, Mental (especially one that inhibits impartial
accounting, Risk seeking, and judgement) or an unfair act or policy
Traditional finance. stemming from prejudice.

B Behavioural Finance Micro (BFMI) Biased expectations

The study of the behavioural biases Investors have biased expectations if
Bankers’ acceptance (BA) (that is, irrational behaviours) of they gather and act on information
A commercial draft (i.e., a written individual investors. It compares in an inefficient or biased way.
instruction to make payment) drawn irrational investors to rational investors Biased expectations are a key tenet
by a borrower for payment on a envisioned in classical economic of behavioural finance. See also
specified date. A BA is guaranteed at theory, known as Homo economicus or Behavioural finance and Rational
maturity by the borrower’s bank. “rational economic individual”. expectations.

Bar chart Behavioural Finance Macro (BFMA) Bid-Ask Spread

A type of chart that plots price on the The study of “anomalies” or The amount by which the asking
vertical axis and time on the horizontal irregularities in the overall market price exceeds the bid price; usually
axis. The action in each period (which that contradict the efficient market interpreted as an indicator of the
can be a minute, hour, day, week, hypothesis. liquidity risk for an investment.
month, etc.) is represented on a
vertical bar, with the top of the bar Behavioural question Blind pool
representing the highest price for that A question that seeks to model An investment fund where investors
period and the bottom representing actual client actions in different are presented with general information
the lowest price. In most cases, the circumstances, along the lines of “if about the type of securities that the
opening and closing prices are also this happened, what would you do?” pool management intends to invest
represented: a short horizontal line to in. However, the exact specifications
the left of the vertical bar represents Benchmark creep of the investments are unknown
the opening price while a line to the The upward tendency in longer run and unavailable at the time that the
right represents the closing price. cumulative median manager returns investor commits funds.
due to survivorship bias.
Barbell portfolio Bollinger bands
A debt securities portfolio invested Benchmark index Price bands that are plotted at a
in of one or more bonds with short An index against which the certain number of standard deviations
durations combined with one or more performance of a portfolio is above and below a moving average
bonds with long durations. See also measured. of prices. See also Moving average
Bullet portfolio. envelopes and Price bands.
Benchmark portfolio
A realistic, attainable standard used Bond
to measure the performance of a A debt security secured by physical
portfolio. assets.

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 GLOSSARY G•3

Book-based format Call date Capacity constraints

A system in which debt securities are A day on which the issuer of a debt Limits on the availability of trading
not represented by physical certificates security or preferred share may choose opportunities consistent with the
but are maintained in computerized to buy back the security in full or in manager’s strategy and risk/return
records. part. See also Call feature, Call price, expectations.
and Callable bond.
Bottom-up approach Capital Asset Pricing Model (CAPM)
An active approach to equity Call feature A theory that describes the
investing that begins with a focus on A clause of many debt securities and relationship between the expected
individual stocks. Investors look at preferred shares whereby the borrower return and risk on any asset. The
the characteristics of individual stocks has the right to buy back all or a CAPM asserts that the only risk for
and build portfolios of the best stocks portion of the security at specified which investors can expect to be
in terms of forecasted risk-return times before the final maturity date. compensated is systematic or market
characteristics. A standard call feature includes a risk, because it cannot be eliminated
schedule of the dates and prices at by diversification. See also Systematic
Bought deal which a borrower can buy back the risk and Unsystematic risk.
issue. See also Call date, Call price,
A method of issuing equity or debt
and Callable bond. Capital gain
securities whereby one or a group
of investment dealers takes on the Selling a security for more than its
liability of buying the entire issue Call price purchase price.
and then selling or distributing it to The price at which the issuer of a debt
investors. See also Marketed deal. security or preferred share can redeem Capital securities
the security. See also Call date, Call Subordinated debentures that rank
Break feature, Callable bond, and Canada below all other indebtedness of the
yield call. issuer, but above that of all equity
A term used to describe a situation
where the price crosses above or below stakeholders. See also Capital trust
a trendline. See Trendline. Callable bond security and Preferred securities.
A debt security with a call feature. See
Brownfield development also Call date, Call feature, and Call Capital trust security
price. A type of capital security that
The redevelopment of an abandoned
or underused commercial or industrial resembles a bond issue because it
property, generally in an urban Canada yield call has $1,000 par values and is traded
community. A callable bond with a call price based in the bond market. See also Capital
on the greater of (a) par or (b) the price securities and Preferred securities.
Bullet portfolio based on the yield of an equivalent-
term Government of Canada bond plus Capture ratio
A debt securities portfolio invested in
a specified yield spread. Also known as The relative proportion of after-tax
one or more bonds with roughly equal
a Doomsday call. See also Call price return to pre-tax return.
durations. See also Barbell portfolio.
and Callable bond.
Buy-and-hold Cash flow yield
Candlestick chart The internal rate of return on a
A passive investment strategy in which
A type of chart that records the portfolio of debt securities. See also
a group of securities or managed
open, high, low, and closing price for Internal rate of return.
products is purchased and then held
each period (which can be a minute,
until they are needed to be to meet
hour, day, week, month, etc.). The Client profile
a client’s goals. See also Passive
candlestick chart differs from a bar
investment strategy. A document containing information
chart in that the candlestick for each
about a client that can be used to
period has a real body, which is a box
create an appropriate investment
that visually represents the difference
policy. This includes information about
between the period’s opening and
C the client’s personal and financial
closing prices. When the closing price
situation, goals and objectives,
is higher than the opening price, the
personality, attitude toward investing,
Calendar Anomaly real body is white or empty; when the
experience with investing, willingness
An irregular securities pattern that closing price is lower than the opening
to bear risk, and more. See also
emerges during certain times of the price, the real body is black or filled
Investment policy.
year, such as the January Effect. in. See also Bar chart, Line chart, and
Real body.

© CANADIAN SECURITIES INSTITUTE (2017)

G•4 INVESTMENT MANAGEMENT TECHNIQUES

Client questionnaire Commercial Mortgage-Backed Conference Board Consumer

A series of multiple-choice or open- Security (CMBS) Confidence Index
ended questions designed to acquire A mortgage-backed security backed by A monthly nationwide survey of U.S.
information from a client. Some a pool of commercial mortgages. See consumer confidence released by the
questionnaires have a scoring key also Mortgage-backed security. Conference Board.
to help interpret responses to the
multiple-choice questions. Commercial paper Consensus forecast
An unsecured money market security An average forecast of several
Closed-end fund issued by a corporation, or in asset- economists or analysts.
Closed-end funds can be offered to backed security form, backed by a pool
retail investors by prospectus, but of underlying financial assets. Consolidation
are not subject to the investment See Continuation pattern.
restrictions that apply to mutual funds. Commodity pools
Closed-end funds are often listed on A special type of mutual fund that Continuation pattern
the Toronto Stock Exchange (TSX). can use leverage and engage in short A chart formation that helps if a
selling using derivatives. previous trend (which has ended)
Closed-ended questions is likely to resume after a period
Questions that seek specific pieces of Commodity Trading Manager of consolidation. Also known as a
information. A Canadian-based discretionary futures consolidation. See also Trend.
advisor.
Closed mortgage-backed security Contrarian indicator
A mortgage-backed security backed by Common shares An indicator that suggests buying
a pool of mortgages that do not allow Securities issued by a corporation that a stock when most investors are
the mortgagors (borrowers) to make represent ownership interest in the bearish, and selling a stock when most
early principal prepayments. See also corporation. Common shareholders investors are bullish. See also Public
Mortgage-backed security and Open have voting rights and a claim on short ratio and Put/call ratio.
mortgage-backed security. the company’s residual earnings and
assets, and may be entitled to receive Convertible bond
Coefficient of determination dividends, if declared by the company’s A debt security that is exchangeable
The percentage of the variability in the Board of Directors. into common shares of the issuer
dependent variable (as measured by at the option of the holder. See also
variance) that can be explained by the Company analyst Exchangeable bond.
variability in the independent variable. See Equity analyst.
See also Dependent variable and Convexity
Independent variable. Competitive tender basis A measure of the rate of change in
A type of bid in an auction of debt modified duration as yields change.
Cognitive bias securities (particularly Government A much closer estimate of the actual
Basic statistical, information of Canada fixed-coupon marketable percentage change in the price of a
processing or memory errors that are bonds) in which the amount won bond is the sum of the bond’s modified
common to all human beings. at the auction is based on the bids duration and convexity for a given
submitted, which are accepted in rising change in yield. For option-free bonds,
Collars order of yield until the full amount of convexity is always positive. For bonds
The purchase of an out-of-the-money the auction has been allocated. See with embedded options, convexity can
put while simultaneously writing an also Non-competitive tender basis. be negative.
out-of-the-money call.
Compound interest Correlation coefficient
Collateralized mortgage obligation Interest paid on principal and A standardized measure of the
(CMO) previously earned interest. tendency of two variables to move in
A mortgage-backed bond that the same direction (relative to their
separates mortgage pools into Composite market indices average or expected values) at the
staggered maturity groups (tranches) Indices designed to measure the same time. The correlation coefficient
that reallocate the interest and movements of specified markets, not is equal to the covariance divided
principal payments. Each tranche is benchmark performance. by the product of the two variables’
sold as a separate security and has a standard deviation. Unlike the
different claim on the underlying cash covariance, the correlation coefficient
flow. measures both the direction and
strength of the linear relationship.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G•5

Corridor Credit spread Debenture

The percentage around which an The portion of a debt security’s yield A debt security that is backed only by
asset class is allowed to vary from its spread attributable to the difference full faith and credit of the issuer, rather
strategic weight before it is rebalanced in credit risk. See also Credit risk and than a specific asset.
back. The corridor is also known as the Yield spread.
Tolerance band. Declining stage
Crystallization The fourth and final stage of the
Counter cyclical indicator Is similar to tax-loss harvesting but industry life cycle. This stage is
An indicator or variable that tends to takes the process one step further. characterized by growth rates that are
move in the opposite direction of the After the offset trades are executed, equal to or even less than that of the
economic cycle. See also Pro cyclical more of the security in the gain overall economy.
trend. position is purchased. See also tax-
loss harvesting. Dedicated strategy
Coupon payment An investment strategy that uses debt
The periodic payment of interest on a Cyclical growth industry securities to meet specific targets and
debt security. An industry that shares attributes of goals.
both a cyclical and growth industry.
Coverage universe The industry tends to have long-term Default
The companies covered by a particular growth prospects that vary with the A failure to make timely payment of
equity analyst. See also Equity economic cycle. See also Cyclical interest or principal on a debt security,
analyst. industry and Growth industry. or to otherwise comply with the
provisions of the security’s indenture.
CPI ex-8 index Cyclical industry See also Default risk.
A variant of the Consumer Price An industry with a growth pattern
Index (CPI) that excludes the eight similar to that of the economic cycle. Default risk
components with the most volatile As such, the industry tends to suffer The risk that an issuer of a debt
prices – fruit, vegetables, gasoline, during recessions, but grow during security may be unable to make timely
fuel oil, natural gas, mortgage periods of economic prosperity. principal and interest payments.
interest, intercity transportation, Sometimes referred to as Credit
and tobacco products, as well as the Cyclical trend risk. See also Credit analysis, Credit
effect of changes in indirect taxes A trend following a recurring rating, and Default.
on the remaining CPI components. pattern with four basic components:
Also known as Core CPI. See also expansion, peak, contraction, and Defensive industry
Consumer Price Index. recession. An industry that tends to hold up well
when the economy is in a downtrend,
Credit analysis Cyclical-based approach but does not grow as much as other
An evaluation of a debt security An approach to tactical asset industries when the economy is
issuer’s ability to service and repay its allocation that involves monitoring expanding.
debt. The evaluation typically includes: economic activity, looking for patterns
determining the issuer’s existing that have historically led to stock Dependent variable
obligations and the assets that are market movements. A variable assumed to be influenced by
available as protection for debt holders another variable.
in the event of a default; analyzing
liquidity and borrowing needs; and Descending triangle
analyzing cash flow needs. See also D A triangle with a horizontal support
Credit rating and Default risk.
line and a negatively sloped trend
Day count method line acting as resistance. See also
Credit rating Ascending triangle, Symmetrical
The method of calculating the number
A credit rating agency’s opinion of the of days between coupon payment triangle, and Triangle.
general credit-worthiness of an issuer dates for the purposes of calculating
with respect to a debt security or other the accrued interest on debt securities. Discounted
financial obligation, based on relevant Four day count methods used by A term used to denote that all
risk factors. different segments of the bond market: available information about a security
actual/365, actual/actual, actual/360, or the market as a whole is factored
Credit risk 30/360. into their prices.
The risk that an issuer of a debt
security may be unable to make timely
principal and interest payments. More
accurately termed Default risk.

© CANADIAN SECURITIES INSTITUTE (2017)

G•6 INVESTMENT MANAGEMENT TECHNIQUES

Discounted cash flow model Dollar-weighted return Earnings retention rate

A valuation model that assumes that A measure of a portfolio’s return as The percentage of earnings not paid
a stock’s intrinsic value is equal to the experienced by the investor. Also out as dividends.
present value of a stream of future known as the Money-weighted
cash flows. return. See also Time-weighted Econometrics
return. The use of computer analysis and
Distribution modeling to analyze mathematically
A payment of cash or securities from a Doomsday call the relationship between key economic
company, mutual fund, or investment See Canada yield call. variables.
trust to shareholders or unitholders.
Double taxation Economic forecast
Diversification The same income being taxed in two An economist’s or economics
Combining less than perfectly countries. department’s prediction for the
positively correlated securities into a outcome of a particular economic
portfolio to lower the unsystematic Double tax treaties indicator or event.
risk of the portfolio relative to that Also known as international tax
of the individual securities. See also treaties. The main purpose of which is Economies of scale
Correlation coefficient. to remove double taxation between A barrier to entry that results in higher
two countries. costs for companies without significant
Dividend market share.
A distribution of cash (or in some cases Down trendline
common shares) to shareholders in A line drawn on a chart that connects Economist
proportion to the number of shares a series of descending highs. See also An analyst who researches, collects,
they own. Dividends are paid only Trendline and Up trendline. and analyzes economic data, monitors
when approved by the company’s economic trends, and develops
Board of Directors. See also Regular Downward-sloping yield curve economic forecasts. See also Equity
dividend, Extra dividend, and Stock analyst, Investment strategist,
See Inverted yield curve.
dividend. Quantitative analyst, and Technical
Duration analyst.
Dividend discount model
A measure of bond price volatility that
A valuation model that assume that Efficient frontier
takes into effect the bond’s coupon
a stock’s intrinsic value is equal to the The set of all efficient portfolios.
rate and time to maturity. All else
present value of a stream of future
being equal, the higher the duration
dividends. Efficient market hypothesis
of a bond, the greater its risk. See also
Dollar duration, Macaulay duration A theory that states that asset prices
Dividend rate and Modified duration. fully reflect all available information in
The fixed dividend paid on preferred efficient markets. The theory has three
shares. The dividend rate may be a Dynamic asset allocation different forms, known as the strong
dollar amount or a percentage of par form, the semi-strong form, and the
Rebalancing the portfolio to the long-
value. See also Par value. weak form. Each form assumes that
term, strategic asset mix. Also known
as Portfolio rebalancing. a different amount of information is
Dollar duration reflected in asset prices.
The approximate dollar change of
a bond or bond portfolio given for Efficient portfolio
a given change in yield. See also The portfolio that an investor chooses
E
Duration, Macaulay duration, and to hold that provides the highest
Modified duration. return for a given level of risk or the
Earnings forecast
lowest risk for a given level of return.
Dollar return An analyst estimate of a company’s
The increase or decrease in the dollar future earnings per share.
Emerging growth stage
value of a portfolio over a certain See pioneering stage.
evaluation period, plus the value of any Earnings per share
withdrawals and minus the value of A company’s profit or loss divided
Emerging market hedge fund
any contributions. See also Evaluation by the weighted-average number of
common shares outstanding. See also A hedge fund that invests in equity and
period.
Basic earnings per share and Fully debt securities of companies based
diluted earnings per share. in emerging markets. See also Hedge
fund.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G•7

Emotional bias Exchange-traded fund (ETF)

F
A mental state that arises An ETF represents shares in a basket
spontaneously, rather than through of securities, which may be indexes,
conscious effort. stocks, bonds or commodities. An ETF Face value
is publicly listed on a stock exchange. See Principal.
Empathy
The ability to enter imaginatively into Exclusion Federal reserve beige book
another’s world to understand how the A qualitative notion of risk in which an A summary of reports by the Federal
other person feels. investor is fearful of missing out on a Reserve District Banks on economic
rally in a particular investment or asset conditions in their regions.
Endogenous variable class.
A variable determined by one or more Feedback stage
other variables generated within a Ex-dividend date The third stage of the investment
model. The first day that purchasers of a management process, encompassing:
company’s shares are not entitled to monitor the markets and the client;
Envelopes a declared dividend. Because stock appraise the portfolio’s performance;
See Moving average envelopes. trades settle two business days after and re-balance the portfolio. See also
the trade date, stocks begin to trade Execution stage and Planning stage.
Equity analyst ex-dividend on the first business
day before the record date. See also Financial leverage
An analyst who uses fundamental
Dividend and Record date. A company’s total asset divided by
analysis to estimate the return and risk
from an investment in the common common equity.
shares of companies in a coverage Execution stage
universe, which is normally defined The second stage of the investment First Order Risk
by an industry or sector. Also known management process encompassing a Exposure to changes in the general
as a research analyst or a company single step: select securities. See also direction of interest rates, as well
analyst. See also Coverage universe, Feedback stage and Planning stage. as equity, currency and commodity
Economist, Investment strategist, markets.
Quantitative strategist, and Exogenous variable
Technical analyst. A variable not determined within a Fixed-floater bond
model. A debt security that entitles the
Eurobond holder to a fixed coupon rate for a
A debt security issued in a foreign Expansion stage predetermined period of time after
market and denominated in a currency The second stage of the industry life which the coupon rate becomes
other than that of the market where cycle. This stage is characterized by variable.
the bonds are issued. healthy and continuous growth rates.
Flat yield curve
Evaluation period Exponential moving average A yield curve with a slope near zero,
The time period over which a A type of moving average that gives characterized by short-term interest
portfolio’s performance is being more weight to recent prices than it rates that are exactly or very close to
measured and evaluated. See also does to older prices. See also Moving longer-term rates. See also Inverted
Performance measurement and average, Simple moving average, and yield curve, Normal yield curve, and
Performance evaluation. Weighted moving average. Yield curve.

Exchangeable bond Extra dividend Flight to quality

A debt security that is convertible into A special, one-time dividend paid in A noticeable increase in credit spreads
another debt security at the option of addition to regular dividends, usually in economic downturns. See also
the holder. See also Convertible bond. because the company has a lot of cash Quality spread theory.
on its statement of financial position
Exchangeable debenture structure and no opportunity to invest in Floating-rate security
An equity monetization structure ongoing or new business ventures. See A debt security with a variable coupon
where the shareholder issues to the also Dividend, Regular dividend, and rate that changes in response to
bank an exchangeable debenture with Stock dividend. changes in another benchmark or
a term to maturity of 20 to 25 years in interest rate. See also Coupon rate.
exchange for cash.

© CANADIAN SECURITIES INSTITUTE (2017)

G•8 INVESTMENT MANAGEMENT TECHNIQUES

Flow-through share Head-and-shoulders top formation

G
A type of common equity issued by A head and shoulder formation that
junior resource companies. Exploration appears at the end of a bull market.
companies renounce certain deductible Generally Accepted Accounting See also Head and shoulders
expenses incurred in the running of Principles (GAAP) formation and Head-and-shoulders
their businesses. These deductions are Rules, conventions, and guidelines bottom formation.
flowed through to investors. used to prepare financial statements.
Hedge fund
Foreign bond Goal shortfall A lightly regulated pool of capital that
A debt security issued and sold in a The probability of not meeting one or has great flexibility in the execution of
domestic market by a non-domestic more personal or financial goals. their investment strategies.
government or corporation. See also
Eurobond. Gordon growth model Heuristics
A dividend discount model that Simple, efficient rules of thumb.
Free Cash Flow to Equity (FCFE) assumes dividends will grow at a
Cash flow available to a company’s constant rate forever. Also known as High-yield bond
common shareholders after paying the constant growth model. See also A debt security with a credit rating
all operating expenses and interest Dividend discount model. of BB (or equivalent) or lower. Also
and principal on its debt, and after known as a junk bond. See Credit
investing in working capital and fixed Gross Domestic Product (GDP) rating and Investment grade bond.
assets. The market value of goods and services
produced by labour and capital in a Home bias
Free Cash Flow to the Firm (FCFF) country. An investing bias created when
Free cash flow to equity plus after- individuals favour investments in
tax interest expense minus net new Growth industry their home market despite ample
borrowing. See also Free cash flow to An industry with a successful rate of opportunities abroad to increase the
equity. growth no matter how the economy is efficiency of their portfolios.
performing.
Fully diluted earnings per share Horizontal resistance
A company’s earnings per share based Growth stock A horizontal resistance level. See also
on the weighted average number of A stock with a high price-to-book Resistance level.
common shares outstanding plus the ratio. See also Value stock.
number of shares that the company Horizontal support
would have to issue if all stock options
A horizontal support level. See also
and warrants were exercised and all
Support level.
convertible securities were converted. H
See also Basic earnings per share and
Housing starts
Earnings per share.
Head-and-shoulders bottom A monthly survey (conducted
formation independently in both Canada and the
Fundamental anomaly
A head and shoulder formation that U.S.) measuring the number of new
An irregularity in a security’s current
appears at the end of a bear market. housing units started during the survey
price when compared to a fundamental
Also known as an inverse head-and- period.
assessment of its intrinsic value.
shoulders formation. See also Head-
and-shoulders formation and Head-
Future value
and-shoulders top formation.
A sum of money to be received in the
I
future, or the value on a future date Head-and-shoulders formation
of money that has been invested at a
A reversal formation that gets its Indenture
known interest rate.
name from its similarity to a human A formal document that outlines
head and shoulders silhouette. The the features of a debt security, the
Futures Contract
formation is defined by four key obligations of the issuer, and the rights
A legally binding agreement traded on features: a left shoulder, a head, a
a regulated futures exchange. of the investor under the contract.
right shoulder, and a neckline. See
also Head-and-shoulders bottom
Independent variable
formation, Head-and-shoulders top
A variable assumed to influence
formation, and Reversal formation.
another variable.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G•9

Index ratio Institute of Supply Management Intramarket spread strategy

For Government of Canada real (ISM) Manufacturing Index A debt securities strategy that
return bonds, the ratio of the current A monthly national survey of American involves swapping bonds that are
consumer price index (CPI) to the base purchasing and supply executives from largely similar. The investor may have
CPI. The index ratio is used to calculate over 400 industrial companies. identified mispriced securities, or may
the inflation compensation. See also see relative value differences between
Consumer price index, Inflation Interest two bonds from two different issuers
compensation, and Real return bond. Money charged by a lender to a in the same business sector. Also
borrower for the use of his or her known as a substitution swap. See also
Indexing money. Intermarket spread strategy.
A passive investment strategy,
supported by the efficient market Interest rate risk Inverse head and shoulders
hypothesis, designed to track the The portion of a debt security’s total See Head-and-shoulders bottom
performance of a specific market risk that is related to fluctuations in formation.
index. See also Efficient market the general level of interest rates,
hypothesis and Passive investment as represented by the yields on Inverted yield curve
strategy. federal government bonds. See also A downward or negatively-sloped yield
Systematic risk. curve characterized by short-term
Industrial capacity utilization rate interest rates that are greater than
A measure (calculated independently Interest rate volatility theory longer-term rates. See also Flat yield
in both Canada and the U.S.) of the A theory used to explain the behaviour curve, Normal yield curve, and Yield
intensity with which industries use of spreads on bonds with embedded curve.
their production capacity, expressed as options. According to the theory, yield
the percentage of actual to potential spreads on callable bonds widen during Investment constraints
output. times of greater interest rate volatility, Factors that limit in some way the
and narrow during times of lower securities that may be included in
Industrial Product Price Index (IPPI) volatility. Yield spreads on putable a client’s portfolio, expressed as
An indicator of the rate of change for bonds react in the opposite manner. the client’s time horizon, liquidity
goods and services sold by Canadian See also Yield spread. requirements, tax situation, legal and
producers. regulatory requirements, and any other
Interlist unique circumstances.
Industry momentum The act of listing securities on more
The tendency of an industry or than one exchange. Many Canadian Investment grade bond
sector to continue to outperform companies interlist their common A debt security with a credit rating of
other industries or sectors. See also shares on both the Toronto and New BBB (low) (or equivalent) and higher.
Momentum ranking. York Stock Exchanges. See also Credit rating and High-yield
bond.
Industry momentum ranking Intermarket spread strategy
A ranking of industry performance A debt securities strategy that Investment management process
over the past several periods. The attempts to capitalize on the difference An integrated and continual process
ranking indicates the consistency of in yield spreads and expected changes designed to meet specific goals and
an industry’s performance relative to in yield spreads between different objectives within a set of constraints.
others and the broad market. See also sectors of the bond market. See also
Industry momentum. Intramarket spread strategy. Investment objectives
Statements that describe what a client
Inflation compensation Internal rate of return is trying to achieve from the portfolio,
An adjustment to a real return bond’s An interest rate that equates the price expressed in terms of a return and risk
principal representing the cumulative or value of a security or portfolio of objective.
level of inflation from the bond’s issue securities to the present value of the
date. For Government of Canada security or portfolio’s future cash Investment policy
real return bonds, the inflation flows. An investing plan that supports
compensation equals the bond’s and reinforces the investment
principal multiplied by the index ratio, Interviewing management process for a particular
minus the bond’s principal. See also The process of gathering information client.
Index ratio and Real return bond. about a client’s investment objectives,
personal circumstances, and frame
Infrastructure of reference. This is accomplished by
Refers to such projects as roads, ports, guiding the discussion or probing.
airports and water works.

© CANADIAN SECURITIES INSTITUTE (2017)

G • 10 INVESTMENT MANAGEMENT TECHNIQUES

Investment policy statement Key reversal Liquidity requirements

A document that lays out, in a A reversal formation that marks the The actual and potential cash needs of
formalized manner, a client’s end of a trend. At the start of a key a client.
investment policy. reversal, prices continue to move
strongly in the direction of the trend,
Investment strategist reaching a new high (in the case of an
An analyst who analyzes and up trend), or a new low (in the case of M
comments on a wide variety of a downtrend). By the end of the day,
investment themes, including asset however, the price has closed lower
Macaulay duration
allocation, market valuation and (in the case of an uptrend) or higher
(in the case of a downtrend) than the The weighted-average term to
forecasts, sector/industry analysis, and maturity of the cash flows from a
individual stock selection. Also known previous day’s close. See also Reversal
formation. bond, where the weights are the
as a market strategist, portfolio present value of the cash flow divided
strategist, or just strategist. by the price. Macaulay duration can be
used to calculate modified duration.
Investment strategy See also Dollar duration, Duration
A description of the process used to L and Modified duration.
select individual securities or managed
products to meet a client’s strategic Labour Force Survey (LFS) Macroeconomic approach
and tactical asset allocation strategy. A monthly household survey A top-down approach to equity
See also Active investment strategy conducted by Statistics Canada. It investing that begins with macro- and
and Passive investment strategy. includes the calculation of Canada’s microeconomic analysis of trends and
unemployment rate. market forecasts in the global, North
Issuer extendible note American, and Canadian economies.
A debt security for which the issuer has Land banking The investor then selects industries
the right at certain points (normally The purchase of a tract of raw land or sectors with the potential to
the anniversary date of issue) either to outside an urban area with the outperform other sectors, given the
allow the bond to mature, or to extend expectation that the urban area will expected economic outlook. Within
the maturity. expand because of economic growth in each sector, the investor chooses
the region. individual stocks, usually large-cap
stocks, to maximize liquidity. See also
Large-cap stock Top-down approach.
J A stock with a large market
capitalization. See also Small-cap Managed product
January effect stock. A security created solely for the
The effect where stocks in general, purpose of investing in a portfolio of
and small stocks in particular, move Legal requirements other securities according to a specific
abnormally higher during the month Any legal issues that limit or restrict investment mandate. See also Closed-
of January. the way a portfolio is managed. See end fund, Exchange-traded fund,
also Regulatory requirements. Hedge fund, and Mutual fund.
Junior issuer
The term given to a company whose Leveraged buyout Management fee
securities are listed on the TSX Venture The majority buyer of a company’s The fee charged by the manager of a
Exchange. See also Senior issuers. shares finances this purchase through managed product. The fee is usually
debt, often with the assets of the stated as a percentage of the fund’s
Junk bond acquired company used as collateral net assets. See also Managed product.
See High-yield bond. for the loan.
Management’s Discussion and
Line chart Analysis (MD&A)
A type of chart that plots a single An important section of a company’s
value only. See also Bar chart and annual report that provides insight into
K
Candlestick chart. the company that is not provided in
financial statements or the notes to
Key drivers the financial statements.
Liquidity ratio
Financial statement items that
significantly influence the values of A ratio that measures a company’s
ability to generate cash from its assets Marginal tax rate
other financial statement items. The amount of tax paid on an
and indicate its ability to meet its
short-term obligations. additional dollar of ordinary income.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G • 11

Market impact Merger arbitrage hedge fund Moving average convergence-

The potential impact on the price of A hedge fund that invests divergence (MACD)
an investment caused by buying or simultaneously in long and short An oscillator that measures the
selling it. positions in the common stock of difference between a short-term
companies involved in a proposed and longer-term exponential moving
Market strategist merger or acquisition. See also Hedge average. In practice, the MACD
See Investment strategist. fund. oscillator is usually accompanied by
an exponential moving average of
Market timer Mezzanine capital the oscillator. See also Exponential
Private equity financing by use of high- moving average and Oscillator.
See Sector rotator.
yield, unsecured preferred equity or
subordinated loans. Moving average envelopes
Marketed deal
Price bands that are plotted at a fixed
A method of issuing equity or debt
Modern portfolio theory percentage above and below a moving
securities whereby one or a group of
A theory that states that investors can average of prices. See also Bollinger
investment dealers attempt to pre-sell
reduce the total risk of their portfolios bands and Price bands.
the issue to clients before bringing
them to market. See also Bought deal. by owning smaller amounts of a
group of less than perfectly positively Multiple voting common shares
Mature stage correlated assets rather than larger Common shares that have more
amounts of an individual asset. than a single vote per share. See
The third stage of the industry life
also Common shares, Non-voting
cycle. This stage is characterized
Modified duration common shares, Restricted voting
by steady and reliable (though
The approximate percentage change common shares, and Subordinated
unspectacular) growth rates.
in a bond’s price for a 100-basis point voting common shares.
Maturity date change in its yield. See also Duration
and Macaulay duration. Mutual fund
The date on which the issuer of a debt
An open-ended managed product,
security must repay the principal to
Money market security structured either as a corporation or
investors. See also Principal.
A debt security initially issued with a as a trust, that raises capital by issuing
term to maturity of one year or less. shares (in the case of a mutual fund
Mean-variance analysis
See also Term to maturity. corporation) or units (in the case of a
The process of selecting the efficient mutual fund trust). The capital is used
portfolio using either a quadratic to purchase securities according to the
formula or a feel for the client’s Money-weighted return
fund’s investment mandate. See also
objectives and risk tolerance. See Dollar-weighted return.
Managed product.

Medium-term note (MTN) program Morningstar tax-cost ratio

A method of issuing debt securities Determines the percentage of assets
whereby issuers file shelf prospectuses, lost to tax after distributions.
N
which allow them to issue a wide
variety of securities, up to a maximum Mortgage-backed security (MBS)
Net profit margin
amount, over an extended period of A type of asset-backed security that
time. The benefit of an MTN program is backed by a pool of mortgages. See A company’s net income divided by
for the issuer is that the securities also Asset-backed security. total sales or revenue.
can be issued on very short notice,
because there is no need to prepare Moving average Net realized capital gains
a new prospectus each time an issue An average of prices over a certain Realized capital gains minus realized
is brought to market. See also Shelf period of time. See also Exponential capital losses. See also Realized
prospectus. moving average, Simple moving capital gain and Unrealized capital
average, and Weighted moving gain.
Mental accounting average.
A phenomenon whereby people Non-competitive tender basis
do not treat their assets as a single A type of bid in an auction of debt
portfolio, but keep track of them securities whereby the bid is accepted
separately. Mental accounting is a key in full and bonds are awarded at the
tenet of behavioural finance. See also auction average. See also Competitive
Behavioural finance. tender basis.

© CANADIAN SECURITIES INSTITUTE (2017)

G • 12 INVESTMENT MANAGEMENT TECHNIQUES

Non-registered account Optimizer

O
Accounts for which investment returns, A computer-based application used
except unrealized net capital gains, to determine a client’s strategic
are taxed as they are earned. See also Off-the-run issue asset allocation. See Strategic asset
Registered account. All non-benchmark Government of allocation.
Canada securities. See also On-the-
Non-style-based approach run issue. Oscillator
A group of investment strategies An indicator that fluctuates between
that do not focus on a particular Offering memorandum two values. There are two classes
group of stocks but involve a search A legal document stating the of oscillators: one class fluctuates
for stocks with the best chance of objectives, risks, and terms of between two fixed values and the
meeting particular objectives. See also investment involved with a private other is not bound by fixed values. See
Pure fundamental approach, Pure placement. also Moving average convergence-
quantitative approach, and Pure divergence (MACD), Relative
technical approach. On-the-run issue strength index (RSI), and Stochastic.
A benchmark Government of Canada
Non-voting common shares debt security. On-the-run issues, which Outside day
Common shares with no voting are usually the most liquid security For a key reversal, if prices close lower
privileges. Most non-voting common in their maturity ranges, eventually than the previous day’s low (in the
shares, however, give shareholders become off-the-run issues. See also case of an uptrend) or higher than the
limited voting rights or full voting Off-the-run issue. previous day’s high (in the case of a
rights under certain circumstances. See downtrend). See also Key reversal.
also Common shares, Multiple voting Open-ended questions
common shares, Restricted voting Questions that invite clients to talk Overlay management
common shares, and Subordinated about themselves require more than a A service that combines several
voting common shares. yes or no answer and allow advisors to managed investment products into a
get to know them better. single account controlled by a single
Normal distribution authority. Under overlay management,
A probability distribution that is Open mortgage-backed security customization and efficient
symmetrical around its expected A mortgage-backed security backed by rebalancing are more efficient than
return. See also Expected return and a pool of mortgages with clauses that under combined separate accounts.
Probability distribution. permit the mortgagors (borrowers)
to make early principal prepayments,
Normal portfolio in addition to the regularly scheduled
A specialized benchmark that includes principal and interest payments. See P
all the securities that a manager Closed mortgage-backed security
normally selects from. and Mortgage-backed security. Par value
The stated face value of a bond or
Normal yield curve Operating performance ratio
stock (as assigned by the company’s
An upward- or positively-sloped yield A ratio that helps to determine a charter) expressed as a dollar amount
curve characterized by short-term firm’s long-run growth and survival per bond or share. The par value of a
interest rates that are lower than prospects. common share has little relationship
longer-term interest rates. See also to the current market value or the
Flat yield curve, Inverted yield curve, Operational risk amount a shareholder may receive
and Yield curve. The risk that a hedge fund may lack if the company was to be liquidated,
the organizational depth, managerial therefore many common shares are
Notes to financial statements talent and strategic planning issued without par value. The par value
A comprehensive set of information capabilities necessary to ensure growth of a preferred share is significant as it
that explains a company’s accounting or even survival. indicates the dollar amount of assets
policies and provides more detailed each preferred share is entitled to
information on individual items in the Optimization approach should the company be liquidated. See
company’s financial statements. A bond indexing approach that builds also Principal.
on the stratified sampling approach
by using mathematical programming Parallel shift of the yield curve
to optimize the portfolio, based on An approximately equal increase or
the stated return objectives and decrease in the yields of debt securities
constraints. See Stratified sampling at all maturities.
approach.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G • 13

Passive investment strategy Policy return Price bands

An investment strategy that does not The return on the portfolio based A pair of lines graphed above and
use expectations about individual on the strategic asset allocation below the price or a moving average of
securities to build a portfolio. The most decision. The return on each asset the price. The lines are used to indicate
popular passive investment strategy class benchmark is weighted by its support and resistance levels. See also
is indexing. See also Buy-and-hold, contribution to the strategic asset Bollinger bands and Moving average
Indexing, Investment strategy, and allocation. envelopes.
Active investment strategy.
Pool factor Price discovery
Passively managed fund The percentage of original principal The process of determining the prices
A managed product whose manager remaining in a pool of mortgages of assets in the marketplace through
makes investment decisions based backing a mortgage-backed security. the interactions of buyers and sellers.
on some criteria other than his or her See also Mortgage-back security.
outlook for the markets and securities. Principal
The most common form of passive Portfolio rebalancing The amount that an issuer of debt
management is indexing. See also Rebalancing the portfolio to the long- securities must repay to investors. This
Actively managed fund. term, strategic asset mix. Also known usually occurs on the maturity date,
as Dynamic asset allocation. but partial repayments can occur prior
Peer group to maturity. Also known as the face
A group of managed products Portfolio strategist value or par value. See also Par value,
(particularly mutual funds) with a See Investment strategist. Amortization schedule and Maturity
similar investment mandate. date.
Portfolio turnover
Performance evaluation Is roughly defined as the total value Principal-protected note (PPN)
The appraisal of a portfolio’s of securities bought and sold in A debt instrument issued by a bank in
performance over the evaluation relation to the overall net assets of the the form of a deposit note.
period. See also Evaluation period. portfolio.
Pro cyclical indicator
Performance measurement Potential rate of growth An indicator or variable that tends to
The calculation of the return realized The rate at which an economy should move in tandem with the economic
by a portfolio over the evaluation grow when all resources (labour and cycle.
period. See also Evaluation period. capital) are fully utilized.
Probing
Periodic Cash Flow Preferred securities Using statements that require the
A client’s income needs during A type of capital security that client to respond with information.
retirement. resembles a preferred share because
it has a $25 par value and is traded Producer Price Index (PPI)
Pioneering stage on a stock exchange. See also Capital A family of U.S. indexes that indicate
The first stage of the industry life cycle. securities and Capital trust security. price changes received by producers of
This stage is characterized by high but goods and services.
volatile growth rates. Prepayment risk
The risk that the issuer of the bond Product differentiation
Planning stage might prepay or redeem early some or A barrier to entry that limits the
The first stage of the investment all principal outstanding on the loan or success of a competing product
management process encompassing mortgage. or service due to a lack of brand
three steps: determine investment recognition.
objectives and constraints; create an Present value
investment policy statement; and A sum of money in hand, or the current Projected financial statements
establish a strategic asset allocation. value of a sum of money that will be A set of forecasted financial
See also Execution stage and received sometime in the future. See statements.
Feedback stage. also Future value and Time value of
money. Protective put
A long position in an underlying
asset and a long put option on the
underlying asset.

© CANADIAN SECURITIES INSTITUTE (2017)

G • 14 INVESTMENT MANAGEMENT TECHNIQUES

Proxy Pure technical approach Quartile ranking

A document that provides shareholders A bottom-up approach to active equity A method of ranking a mutual fund’s
with information on company investing that assumes all known performance relative to its peer group.
matters to be voted on and a form to market influences are fully reflected in See also Mutual fund, Peer group,
register his or her vote. It also allows market prices, and that nothing is to and Quartile.
a shareholder to authorize others, be gained by conducting fundamental
usually the company’s management, analysis. Investment decisions are
to vote on behalf of the shareholder made by analyzing historical market
in the manner that the shareholder action to determine probable future R
has indicated, without the shareholder price trends. See also Non-style-
being present. based approach, Pure fundamental
Rapid growth stage
approach, and Pure technical
approach. See Expansion stage.
Public short ratio
A contrarian indicator based on data
Put/call ratio Rating category
published by stock exchanges. The
ratio is equal to the total number of A contrarian indicator that compares A statement about the expected return
short sales of the public divided by the the number of put options traded on a stock relative to all other stocks in
total short sales. See also Contrarian during a session with the number an equity analyst’s coverage universe.
indicator. of call options. See also Contrarian See also Coverage universe and
indicator. Equity analyst.
Pure fundamental approach
Putable bond Ratio analysis
A bottom-up approach to active equity
investing that involves an analysis of See Retractable bond. The analysis of liquidity, risk analysis,
a company’s historical and projected operating performance, and value
financial performance and valuation. ratios to help forecast company
See also Non-style-based approach, performance. See also Liquidity
Pure quantitative approach, and Pure ratio, Risk analysis ratio, Operating
Q performance ratio, and Value ratio.
technical approach.
Quality spread theory Rational expectations
Pure play
A theory that attempts to explain the Investors have rational expectations if
A reference to a commodity- behaviour of credit spreads. According
producing company’s operation whose they all gather and act on information
to the theory, credit spreads narrow in an efficient and unbiased way.
revenues are 100% dependent on the during economic upturns, and widen
production of the raw commodity See also Biased expectations and
during economic downturns. See also Traditional finance.
itself. Credit spread and Flight to quality.

Pure quantitative approach Real body

Quantitative analyst A box used in candlestick charts that
A bottom-up approach to active equity An analyst who combines historical
investing that combines historical visually represents the difference
fundamental data with statistical between each period’s opening and
fundamental data (earnings, cash analyses using computer- based
flow, book value, etc.) with statistical closing price. See also Candlestick
models to identify the best stocks chart.
analysis using computer-based models according to pre-specified criteria.
to identify the best stocks according See also Economist, Equity analyst,
to pre-specified criteria. See also Real estate
Investment strategist, and Technical
Non-style-based approach, Pure Refers to land and/or any of the fixed
analyst.
fundamental approach, and Pure assets (residences, buildings, and
technical approach. factories) built upon it.
Quartile
The division of mutual funds into four Real estate investment trust (REIT)
approximately equal-sized groups
An income trust that invests in and
based on performance. The first or
manages a diversified portfolio of real
top quartile contains the funds with
estate assets.
performance in the top quarter of all
funds in the group, the second quarter
Realized capital gain
contains the funds with performance
in the next quarter, and so. See also The profit earned on a security when it
Quartile ranking. is sold for more than what was paid for
it. See also Net realized capital gains
and Unrealized capital gains.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G • 15

Real return bond Registered Retirement Income Fund Relative Wealth Measure (RWM)
A debt security with coupon payments (RRIF) The RWM measures the amount per
and principal indexed to inflation. A government-sponsored account $1,000 of assets that needs to be
See also Index ratio and Inflation used to fund an individual’s retirement. invested at the pre-tax return to pay
compensation. The tax on investment returns earned the tax liability.
within the account is deferred until
Rebalancing money is withdrawn. A minimum Research analyst
Returning a portfolio back to its amount of money must be withdrawn See Equity analyst.
strategic asset allocation. See from the account each year during
also Temporal rebalancing and retirement. See also Registered Residual
Rebalancing by weights. account.
A debt security representing a fixed-
coupon bond’s principal that has been
Rebalancing by weights Registered Retirement Savings Plan stripped from the coupon payments.
Rebalancing a portfolio in response to (RRSP) See Strip coupon.
fluctuations in the value of each asset A government-sponsored account used
class. See also Rebalancing. to save for an individual’s retirement. Resistance level
Contributions (up to a certain amount)
The price point(s) at which investors
Recommended list are tax deductible and the tax on
believe a stock is fully valued or
investment returns earned within
A list of best stock picks issued by an possibly even overvalued. At this
the account is deferred until money
investment dealer or other provider of point, perceived return potential is
is withdrawn. See also Registered
equity research. limited, and many holders of the
account.
stock (or short sellers) are willing to
Record date sell. Because of the limited return
Regret potential, potential buyers are
The date on which a shareholder must
A qualitative notion of risk in which an unwilling to buy. Prices tend to fall
own a company’s shares to be entitled
investor dwells upon past mistakes, as supply overwhelms demand. See
to a declared dividend. See also
leading to increased timidness also Horizontal support, Horizontal
Dividend and Ex-dividend date.
regarding future investment decisions. resistance, and Support level.
Registered account
Regular dividend Restricted voting common shares
An account for which contributions
A dividend shareholders may expect to Common shares that limit the
are tax-deductible and/or the tax on
receive on an ongoing basis. See also number or percentage of votes given
investment returns is deferred to a
Dividend, Extra dividend, and Stock to shareholders, or which limit the
later date or not taxed at all. See also
dividend. matters on which shareholders can
Registered Retirement Savings Plans
(RRSPs), Registered Retirement vote. See also Common shares,
Income Funds (RRIFs), Registered Regulatory requirements Multiple voting common shares,
Educational Savings Plans (RESPs), Any regulatory issues that limit or Non-voting common shares, and
and Tax-Free Savings Accounts restrict the way a portfolio is managed. Subordinated voting common
(TFSAs). See also Legal requirements. shares.

Registered Education Savings Plan Relative Strength Index (RSI) Retractable bond
(RESP) An oscillator that measures the A debt security that gives the holder
A government-sponsored account used strength of price gains on days that the right to request repayment of
to finance a child’s post-secondary a stock closes up versus the strength principal from the issuer before
education. The tax on investment of price declines on days that a stock maturity. Also known as a putable
returns earned within the account is closes down. See also Oscillator. bond.
deferred until money is withdrawn. See
also Registered account. Relative valuation model Return objective
A valuation model that determines A measure of how much the client’s
intrinsic value by comparing one or portfolio is expected to earn each year
more of the stock’s value ratios or on average.
price multiples (such as price-earnings,
price-to-book, or price-to-sales ratios) Return of Capital
to a benchmark value for the price Trust or fund distributions in excess of
multiple. the taxable income investors should
receive.

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G • 16 INVESTMENT MANAGEMENT TECHNIQUES

Return On Equity (ROE) Risk seeking Sector perform

Profit divided by common equity. ROE Investors are risk-seeking if, given the A typical rating category that indicates
can also be calculated as the product choice between investments with that the expected return on a stock
of a company’s net profit margin, identical expected returns, they invest is about the same as that of other
total asset turnover, and financial in the one with the greatest amount companies in an equity analyst’s
leverage. See also Net profit margin, of risk. Risk-seeking behaviour by coverage universe. See also Coverage
Total asset turnover, and Financial investors in certain situations is a universe, Equity analyst, and Rating
leverage. key tenet of behavioural finance. See category.
also Risk aversion and Behavioural
Reversal formation finance. Sector rotator
A chart pattern that helps confirm if An investor who follows a
a trend reversal has taken place. See Risk tolerance macroeconomic approach to top-down
Trend reversal. A specific statement of how much investing. See also Macroeconomic
risk the client can sustain to meet approach.
Riding the yield curve the return objective. Risk tolerance
An active fixed income strategy that depends on the client’s willingness and Sector underperform
involves buying a bond with a maturity ability to bear risk. A typical rating category that indicates
much longer than the investor’s time the expected return on a stock is lower
horizon. If the yield curve is upward Risk-adjusted return measures than that of other companies in an
sloping and its shape and level are A measure of return that takes into equity analyst’s coverage universe.
expected to remain unchanged, the account the level of risk taken to earn See also Coverage universe, Equity
bond will increase in price with time. the return. Also, the returns generated analyst, and Rating category.
by a fund compared to the level
Risk analysis ratio of risk taken to earn those returns. Secular trend
A ratio used to determine how Because risk-adjusted return measures A trend that unfolds over many
well a company deals with its debt incorporate both the risk and return of years or decades, and which may be
obligations. a fund, they can be used to compare comprised of shorter cyclical trends.
funds with different investment See also Cyclical trend.
Risk arbitrage hedge fund mandates. See also Sharpe ratio and
Alpha. Security selection
See Merger arbitrage hedge fund.
The selection of securities for inclusion
Roll yield risk in a portfolio.
Risk aversion
The risk of loss in a futures contract-
Investors are risk-averse if, given the
based ETF on the price convergence Senior issuer
choice between investments with
between the commodity futures
identical expected returns, they invest The term given to a company whose
contract and the commodity’s spot
in the one with the least amount securities are listed on the Toronto
price.
of risk. See also Risk seeking and Stock Exchange (TSX). See also Junior
Traditional finance. issuers.

Risk objective Separately Managed Account

Defines the amount of risk the client
S A client management system where a
can tolerate to meet the return new account is opened for each new
objective. A client’s risk objective is a Second Order Risk managed account manager or product.
function of their risk tolerance, which Risks that are not related to the market
in turn depends on their willingness but to other aspects of trading, such Sharpe benchmark
and ability to bear risk in their as dealing, implementing arbitrage A benchmark constructed by
portfolio. See also Return objective structures, or pricing illiquid or combining a variety of style indices. It
and Risk tolerance. infrequently valued securities. is created statistically using multiple-
regression analysis.
Risk premium Sector outperform
A measure of the expected return on A typical rating category that indicates Sharpe ratio
an asset class minus the expected that the expected return on a stock is The excess average return per unit of
return on another asset class. greater than that of other companies in total risk for a given time period. See
an equity analyst’s coverage universe. also Risk-adjusted return.
See also Coverage universe, Equity
analyst, and Rating category.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G • 17

Shelf prospectus Stochastic oscillator Style-based approach

A prospectus filed with the appropriate An oscillator that measures whether a A bottom-up approach to active
regulators that allow a company to stock is closing near its highs and lows, equity investing that focuses on a
issue debt securities over an extended which is a strong characteristic of a particular set of stocks that have
period of time. See also Medium-term trending market. See also Oscillator. similar fundamental characteristics
note (MTN) program. and performance patterns. Also a
Stock dividend top-down approach to active equity
Simple moving average A dividend paid in the form of investing that focuses on whatever
The most popular type of moving additional common shares rather style offers the opportunity to
average. A simple moving average is than cash. See also Dividend, Extra outperform at a particular point in
determined by summing the closing dividend, and Regular dividend. time. See also Growth stock, Large-
prices for a certain number of periods cap stock, Small-cap stock, Value
and then dividing by the number of Strategic asset allocation stock, Bottom-up analysis and Top-
periods. Simple moving averages down analysis.
The benchmark asset mix designed
give equal weight to each period’s to achieve a client’s longer-term
price. See also Exponential moving objectives while taking into account Style drift
average, Moving average, and any constraints. See also Asset The phenomenon that occurs when
Weighted moving average. allocation, Asset class, and Tactical managers stray from their intended
asset allocation. style.
Simple regression analysis
A statistical technique that determines Strategic trading Subordinated voting common shares
the linear relationship between two Trading that establishes and maintains Common shares that have fewer voting
variables from historical data. One a portfolio’s strategic asset allocation. rights per share than another class of
variable, known as the independent Because the strategic asset allocation common shares. See also Common
variable, is assumed to influence the is a long-term asset mix, strategic shares, Multiple voting common
dependent variable. trading tends to be infrequent. See also shares, Non-voting common shares,
Tactical trading. and Restricted voting common
Small-cap stock shares.
A stock with a small market Strategist
capitalization. See also Large-cap See Investment strategist. Superficial loss rules
stock. Tax rules that states investors cannot
Stratified sampling approach buy the same security within 30
Specific risk days before or after the loss trade.
A bond indexing approach that takes
See Unsystematic risk. In addition, the capital loss may be
a market index and divides it into
applied only to the cost base of the
parts or cells representing different
Square One Approach original security.
portfolio characteristics, such as
An itemized listing of all expenses duration, coupon, maturity, sector,
expected during retirement in line with credit rating, and call features. The Support level
the lifestyle needs identified through goal is to choose securities that The price point(s) at which the
discovery. It is the most precise best represent the characteristics of majority of investors sense value
method (if future expenses can be an entire cell. The cells are then placed and are willing to buy more than the
estimated accurately) and the most together in appropriate weights to holders of the stock (or short sellers)
in line with the wealth management adequately approximate the index. See are willing to sell. As demand outstrips
approach. also Optimization approach. supply, prices tend to rise from
support levels. See also Horizontal
Stable stage Strip coupon support, Horizontal resistance, and
Resistance level.
See Mature stage. A debt security that represents a fixed-
coupon bond’s interest payment that
has been stripped from the residual. Survivorship bias
Standard deviation
See also Residual. The tendency to measure the
A statistical measure of risk that
performance of a peer group of
measures the extent to which returns
Stripped MBS funds whose membership has varied
differ from the average or expected
over time. One can evaluate the
level of return. The standard deviation Mortgage-backed securities that divide
performance only of the surviving
is equal to the square root of the the cash flows from the underlying
members of a group, not the past
variance. mortgage security into two or more
performance of the starting group.
new securities.
Standard finance
See Traditional finance.

© CANADIAN SECURITIES INSTITUTE (2017)

G • 18 INVESTMENT MANAGEMENT TECHNIQUES

Sustainable growth rate Tax-Free Savings Account (TFSA) Term structure

The estimated rate of growth of A registered account for which The relationship between interest
earnings and dividends that can be contributions are not tax deductible rates and time to maturity. The term
sustained for a given level of return and investment income earned is not structure is normally represented in
on equity (ROE), assuming the taxed. See also Registered Account. graphical form by a yield curve. See
capital structure of the company also Yield curve.
is constant over time and that no Tax Loss Harvesting
additional common stock is issued. The act of voluntarily taking losses for Terminal value
The sustainable growth rate equals the the purpose of creating a current tax An estimate for the intrinsic value of a
earnings retention rate multiplied by deduction to offset realized gains. The stock on the last forecast dividend or
ROE. See also Earnings retention rate purpose is to minimize tax liabilities cash flow date in a dividend discount
and Return on equity. and keep the asset in the portfolio, or discounted cash flow model.
where it can benefit the most from
Symmetrical triangle compounding. Time diversification
A triangle where the support and A theory that says that, over the long
resistance lines are equal in length Tax management term, equities outperform all other
and slope, although the slope cannot The use of investment accounts, asset classes, and therefore the longer
be horizontal. See also Ascending techniques, and strategies that aim to the time horizon, the lower the risk
triangle, Descending triangle, and reduce or limit the amount of tax paid of holding equities. A belief in time
Triangle. by a client. See also Marginal tax rate diversification usually leads to a
and Tax situation. recommendation that younger clients
Systematic risk hold a greater percentage of their
The portion of a security or portfolio’s Tax situation portfolio in equities than older clients
total risk that is related to fluctuations The complete set of information would.
in the return on the overall market. required to manage a client’s portfolio
See also Capital Asset Pricing Model on a tax-efficient basis, including, Time horizon
(CAPM) and Unsystematic risk. among other things, the client’s margin The length of time expected to elapse
tax rate, RRSP contribution status, and before one of a client’s significant goals
investment income. See also Marginal must be met.
tax rate and Tax management.
T Time value of money
Technical analysis The concept that money received
Tactical asset allocation The study of historical market action today is worth more than the same
The asset mix designed to take (price, volume, and time) to determine amount of money to be received in the
advantage of perceived opportunities probable future price trends. future, because money received today
created by short-term fluctuations can be invested to earn interest up
in the relative performance of asset Technical analyst until that future date. The time value
classes. See also Asset allocation, An analyst who studies historical of money concept is the primary basis
Asset class, and Strategic asset market action (price, volume, and of debt securities valuation. See also
allocation. time) to determine probable future Present value and Future value.
price trends. See also Economist,
Tactical trading Equity analyst, Investment Time-weighted return
Trading that carries out a portfolio’s strategist, and Quantitative analyst. A measure of a portfolio’s return
tactical asset allocation. Tactical that eliminates the effect of investor
trading involves the shifting of Technical anomaly contributions and withdrawals. See
positions or portfolio allocations Is rooted in technical analysis. See also Dollar-weighted return.
in reaction to or in anticipation of Technical analysis.
the day-to-day release of economic Tolerance band
information. See also Strategic Temporal rebalancing The percentage around which an
trading. Rebalancing a portfolio at regular asset class is allowed to vary from its
intervals, such as a monthly, quarterly, strategic weight before it is rebalanced
Tax Efficiency Ratio semi-annually, or annually. See also back. The tolerance band is also known
The measure of how much of a pre-tax Rebalancing. as the Corridor.
return an investor keeps after paying
tax liabilities on realized or unrealized
gains.

© CANADIAN SECURITIES INSTITUTE (2017)

 GLOSSARY G • 19

Top-down approach Trend reversal Unique circumstances

An active approach to equity investing Action that signals a possible end and Any client issues that limit or restrict
that begins with a study of broad reversal of the current trend. See also the way a portfolio is managed and
macro factors before narrowing the Reversal formation. that do not fall under any other
analysis to individual stocks, some of investment constraint category.
which are chosen for investment. Trend line
A line drawn on a chart that connects Unrealized capital gain
Total asset turnover a series of ascending lows (in the case The profit on a security (that hasn’t
A company’s total revenue divided by of an up trendline) or descending been sold) when it is worth more than
total assets. highs (in the case of a down trendline). what was paid for it. See also Net
See also Up trendline and Down realized capital gains and Realized
Total return trendline. capital gains.
A measure of the return on a security
or portfolio that includes both the Treynor Ratio Unsystematic risk
change in the value of the security or A measure of the average excess return The portion of a security or portfolio’s
portfolio and the income generated by per unit of risk. Risk is measured by the total risk that is not related to
the security or portfolio. portfolio’s beta. fluctuations in the overall market.
See also Capital Asset Pricing Model
Total return index Triangle (CAPM) and Systematic risk.
An index that measures the total A chart pattern that consists of a
return on the securities that make up support and resistance line that Up trendline
the index, including price changes and meet – or are projected to meet – A line drawn on a chart that connects
the income paid by the securities in at a point called the apex. The a series of ascending lows. See also
the index. In most cases, it is assumed slope of the support and resistance Down trendline and Trendline.
that the income is reinvested in the lines determines the type of
securities of the index. triangle. Triangles can be reversal Upward-sloping yield curve
or continuation patterns. See also See Normal yield curve.
Tracking Error Ascending triangle, Descending
The error to which an index fund triangle, and Symmetrical triangle.
manager tracks the returns of his
target benchmark. V
Traditional finance U
Value ratio
The group of economic and investment A ratio that gauges the market’s
theories that form the theoretical Unified Household Managed perception of the value of a company’s
underpinnings for the investment Account (UHMA) shares relative to its dividends,
decision-making process. This includes An account that provides all of the earnings, or other measures such as
an assumption that investors are risk features, information and controls the book value of common equity.
averse, have rational expectations, and afforded by a UMA, but is applied to
manage their portfolios as a whole. the client’s entire household and/or Value stock
See also Risk aversion, Rational family office situation, rather than
expectations, and Behavioural A stock with a low price-to-book ratio.
applying it just to the individual client.
finance. See also Growth stock.
Unified Managed Account (UMA)
Tranche Venture Capital
Software tools and data feeds
A division of a mortgage pool that has Private equity financing of new,
that eliminate the shortcoming
a different claim on the cash flows untested companies.
associated with SMAs. The advisor is
of the underlying pool than other able to monitor the client’s overall
tranches. These tranches determine Value-based approach
portfolio of managed accounts to the
how cash flows from the mortgages appropriate level of detail to ensure An approach to tactical asset
are redirected to commercial that all investment guidelines and allocation that identifies when an asset
mortgage-backed securities based restrictions are adhered to and that tax class is cheap and when it is expensive
on the pool. See also Commercial management can be controlled. by comparing the relative value of that
mortgage-backed security. asset class to all other asset classes.
See also Risk premium.
Treasury bill
The shortest-term marketable debt
security issued by governments.

© CANADIAN SECURITIES INSTITUTE (2017)

G • 20 INVESTMENT MANAGEMENT TECHNIQUES

Yield to maturity
W Y
A measure of the rate of return on a
debt security assuming the security is
Weighted average cost of capital Yield held to maturity and the issuer does
A weighed average of the required A measure of the known or estimated not default on its obligations. If these
return on a company’s debt and equity rate of return on an investment. conditions are true, and the debt
securities. The term yield is most frequently security does not pay periodic interest,
associated with debt securities. then the yield to maturity is an exact
Weighted moving average measure of return. If the conditions
A type of moving average that gives Yield curve are true and the debt security does
more weight to recent prices than A graphical representation of the term pay periodic interest, then the yield to
it does to older prices. See also structure of interest rates for a single maturity is an exact measure of return
Exponential moving average, Moving issuer. See also Term structure. only if the interest is reinvested at the
average, and Simple moving average. original yield to maturity.
Yield curve hump
Whipsawed An increase or decrease in the yields Yield to put
Taking a certain position in at or near a certain maturity that is The yield to maturity on a putable
anticipation of the market moving in greater than the change in yields at debt security assuming the put date
a certain direction, only to have the other maturities. is the maturity date. See also Yield to
market reverse and go in the opposite maturity.
direction. Yield curve twist
An increase or decrease in yields at Yield to worst
Whisper estimate one end of the yield curve that is The lowest yield on a callable debt
An unofficial estimate of an economic greater or less than the increase or security taken from the set of yields
forecast or a company’s earnings that decrease in yields at the other end of that includes the yield to all possible
deviates from the consensus forecast. the yield curve, or an increase in yields call dates and the yield to the final
See also Consensus forecast. at one end of the yield curve with a maturity date. See also Yield to call
corresponding decrease in yields at the and Yield to maturity.
Working alliance other end. A yield curve twist causes
The term describes the effort required the yield curve to either steepen or
of both client and advisor and denotes flatten.
a practical partnership.
Yield spread
Wrap accounts The difference between the yields
Accounts for which a qualified on two debt securities, normally
portfolio manager is authorized to expressed in basis points. In general,
select securities and execute trades on the greater the difference in the risk
behalf of a client. The securities can of the two securities, the larger the
include mutual funds, pooled funds, or spread.
individual securities such as stocks and
bonds. Yield to call
The yield to maturity on a callable
Wrap funds debt security assuming the call date
Portfolios of managed products is the maturity date. See also Yield to
“wrapped” together and sold as a maturity.
single product.

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