Online Brokers. The rise of online brokers in the 1990s gave retail investors, espe- cially those that did not have the resources to engage a professional money manager, unfettered access to the market and more control over their invest- ments. Online brokers such as E*TRADE, TD Ameritrade, Scottrade, and Charles Schwab offered very low rates. Today, the aforementioned brokers, along with many others, continue to offer low fees with little to no required minimum bal- ances. Other services (some have an added fee and require minimum balances) also provided include research, stock screeners, educational material, trade assistance, managed accounts, access to financial professional advice, and banking services. Users of online brokers vary from day traders to long term investors.
Robo-Advisors. Robo–advisors offer automated investing focused on creating portfolios that adhere to the tenets of modern portfolio theory and the efficient market hypothesis. The process uses algorithms to create and rebalance portfo- lios, and to harvest tax losses. Portfolios are created with index ETFs, while a few other firms also offer index mutual funds. Generally, prior to the creation of a portfolio, an investor’s risk tolerance is assessed with a few questions or a survey.
Some firms also use goals planning to assist the portfolio creation process. Fees and minimum balances vary by firm, but can be as low as zero for both, with fees decreasing as account balances increase. Although recognized for their auto- mated process, most firms still offer a human touch that can vary from simple customer assistance to professional consultations with an added fee. Arguably robo-advisors benefit those who have minimal investment resources and rela- tively simple financial situations. However, they may not be appropriate for those who prefer professional guidance or have complex financial situations. A few of the recognizable firms in the nascent robo-advisor arena are Betterment, Personal Capital, Vanguard’s personal advisor services, and Wealthfront. Recently Charles Schwab launched its own version, Schwab Intelligent Portfolios.
In this chapter we presented various investment products available in the marketplace. In the next chapter, investment theories and concepts will be presented.
Appendix to Chapter 8: Market Benchmarks
Russell 3000: The index of 3000 large US companies, ranked by market capital- ization. It represents approximately 98 percent of the US equity market.
Russell 1000: The 1000 largest companies in the Russell 3000 index. This index is correlated with the S&P 500 Index.
Russell 1000 Growth: Represents a segment of the Russell 1000 Index with a greater-than-average growth orientation. Companies in this index have higher price-to-book and price-earnings ratios, lower dividend yields, and higher fore- casted growth value.
Russell 1000 Value: Represents a segment of the Russell 1000 Index with a less-than-average growth orientation. Companies in this index have low price- to-book and price-earnings ratios, higher dividend yields, and lower forecasted growth values.
Russell 2000: The 2000 smallest companies in the Russell 3000 Index, represent- ing approximately 10 percent of the Russell 3000 total market capitalization.
Russell 2000 Value: Represents a segment of the Russell 2000 Index with a less-than-average growth orientation. Whereas the Russell 1000 style indices (growth and value) are categorized as either entirely value or growth, the Russell 2000 style indices use a probability methodology that places many securities in both styles. So a company’s available market capitalization can be split between value and growth in proportion to its respective probabilities. With this method- ology, the combined market capitalization of the Russell 2000 Growth and Value indices will total the market cap of the Russell 2000.
Russell 2000 Growth: Represents a segment of the Russell 2000 Index with a greater-than-average growth orientation. Whereas the Russell 1000 style indi- ces (growth and value) are categorized as either entirely value or growth, the Russell 2000 style indices use a probability methodology that places many securities in both styles. As a result, a company’s available market capitaliza- tion can be split between value and growth in proportion to its respective probabilities. With this methodology, the combined market capitalization of the Russell 2000 growth and value indices will add up to the total market cap of the Russell 2000.
Russell Mid-cap: Index consists of the bottom 800 securities in the Russell 1000 index as ranked by total market capitalization, and it represents over 31 percent of the Russell 1000 total market cap.
Russell Mid-cap Growth: Represents a segment of the Russell 1000 Index with a greater-than-average growth orientation. Companies in this index have higher price-to-book and price-earnings ratios, lower dividend yields, and higher fore- casted growth value.
Russell Mid-cap Value: Represents a segment of the Russell 1000 Index with a less-than-average growth orientation. Companies in this index have low price- to-book and price-earnings ratios, higher dividend yields, and lower forecasted growth values.
Wilshire 5000: Measures the performance of all US common equity securities, and so serves as an index of all stock trades in the USA. The returns for the index are total returns, which include reinvestment of dividends.
Standard & Poor 500 (S&P 500): A broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. Currently, it consists of roughly 100 information tech- nology, 85 financial, 75 health care, 65 consumer discretionary, 50 industrial, 50 consumer staples, 35 energy, 15 utility, 15 material, and 10 telecommuni- cation companies listed on US stock exchanges. It is a capitalization-weighted index calculated on a total return basis with dividend reinvested. The S&P 500 represents about 80 percent of the total market capitalization.
S&P 500 Growth: The S&P 500 growth index tracks the performance of those stocks in the S&P 500 with higher price-to-book ratios. It has roughly 330 stocks representing two/thirds of the S&P 500 market cap. Half of these stocks are identified as growth while the other half are not easily identifiable as growth or value. Thus, half of this index overlaps with the S&P 500 value. A cap-weighted index, it is rebalanced annually. This index is currently heavily weighted in the information technology, health care, and consumer discretionary sectors S&P 500 Value: The S&P value index tracks the performance of those stocks in the S&P 500 with lower price-to-book ratios. It has roughly 330 stocks represent- ing two/thirds of the S&P 500 market cap. Half of these stocks are identified as value while the other half are not easily identifiable as growth or value. Thus,
half of this index overlaps with the S&P 500 Growth. A cap-weighted index, it is rebalanced annually. This index is currently heavily weighted in the financial, industrial, and energy sectors.
S&P’s Mid-cap 400 (S&P 400): A measurement of changes in 400 domestic stocks chosen by capitalization, liquidity, and industry group representation. It is a capitalization-weighted index, with each stock’s weight proportional to its market value. The index represents approximately 10 percent of the aggregate market value of US companies. Combined, the S&P Mid-cap 400 and the S&P 500 indices represent about 90 percent of total market capitalization of US domestic public companies.
S&P’s Small-cap 600 (S&P 600): Measures the small cap segment of the market based on 600 stocks. The S&P SmallCap 600 covers approximately 3 percent of the domestic equities market.
The Barclays Capital Aggregate Bond Index: Which used to be called the
“Lehman Aggregate Bond Index,” is a broad base index, maintained by Barclays Capital, which took over the index business of the now defunct Lehman Brothers.
It is often used to represent investment grade bonds traded in the USA.
Barclays Capital US Government Bond Indexes: Barclays Capital has US gov- ernment bond indexes for various maturities—Barclays Capital US Short Treasury Bond Index, Barclays Capital US 1–3 Year Government Bond Index, Barclays Capital US 1–3 Year Government Bond Index, Barclays Capital US Intermediate Government Bond Index, Barclays Capital US 20+ Year Treasury Bond Index, Barclays Capital US Long Government Bond Index, Barclays Capital US Government Bond Index, and so on.
MSCI EAFE: A measurement of the performance of approximately 900 securi- ties listed on the stock exchanges of developed markets in Europe, Australia, and the Far East. It is an arithmetic average weighted by market value, and it is calculated on a total return basis, which includes reinvestment of gross divi- dends before deduction of withholding taxes.
MSCI World: A measurement of the performance of approximately 1,600 secu- rities listed on the stock exchanges of Europe, Canada, Mexico, Australia, US, and the Far East. It is an arithmetic average weighted by market capitalization, and it is calculated on a total return basis, which includes reinvestment of gross
dividends before deduction of withholding taxes. Index created by Morgan Stanley.
MSCI World ex-US: A measurement of the performance of approximately 1,000 securities listed on the stock exchanges of Europe, Canada, Mexico, Australia, and the Far East. It is an arithmetic average weighted by market capitalization. It is calculated on a total return basis, which includes reinvestment of gross divi- dends before deduction of withholding taxes. Index created by Morgan Stanley.
MSCI Emerging Markets: A market capitalization-weighted index of about 800 stocks from 23 emerging economies. Because the countries included (many from Latin America and South East Asia) are less developed, they are more sus- ceptible to economic and noneconomic setbacks. As a result, this index tends to be more volatile than indexes based on of stocks from developed countries.
MSCI ACWI: A market cap weighted index of about 2500 stocks from both developed and emerging markets. This index combines the holdings of the MSCI World and MSCI Emerging Market indices.
Barclays Capital US Municipal Bond Indexes: Barclays Capital replaced Lehman Brothers Municipal bond indexes as well. It has a number of US munic- ipal bond indexes: Barclays Capital US Municipal Bond Index, Barclays Capital 3–15 Year Blend Municipal Bond Index, Barclays Capital Municipal Managed Money Index, and so on.
91 Day Treasury: Representing the monthly return equivalents of yield aver- ages that are not marked to market, this index is an average of the last three three-month Treasury bill issues.
Wilshire Real Estate Index: A measurement of equity REITs and real estate operating companies. No special-purpose or health care REITs are included. It is a market-cap weighted index from which returns are calculated monthly using buy and hold methodology; it is re-balanced monthly.
INTRODUCTION
In this chapter we present the key elements of investment concepts applicable to individual securities and efficient portfolios constructed primarily with mutual funds and ETFs. We begin this chapter with a discussion of the concepts and strategies of individual securities. However, we will devote the majority of the chapter to the theory of portfolio construction and the time-tested strategies of managing investment portfolios consisting solely of mutual funds and ETFs.
Investment can be defined as the commitment of a given sum of money today with expectations for receiving a larger sum in the future. This definition under- scores two important points. First, the investment process is a trade-off of pres- ent income for future income. Second, the objective of the investment is to receive a larger flow of funds in the future. However, that there is a significant difference between investment and speculation. Essentially, speculators con- centrate on returns expected to be received over relatively short periods. In con- trast, investors seek to derive benefits from their investments over a long horizon. Another difference is that speculators act quickly on the available infor- mation not yet analyzed or acted upon by the general public. But investors gen- erally base their judgment on the results of careful investment analysis.