The Financial Advisor's Investment Case

Investment Companies and Asset Allocation

Your clients, Eva and Walther Sachs, operate a successful catering business specializing in Germanic and eastern European foods. It is a family business with part$-$time workers during peak periods. Most of the part$-$time employees have regular full$-$time jobs and work part time for their love of the specialty foods. The business has been profitable for years and consumes a large amount of Eva's and Walther's time. They have accumulated over $$250,000,$ which has been invested solely in a large cap growth mutual fund. They have no retirement accounts and have not thought about an exit strategy in which they would sell or liquidate the business.

You realize that the Sachses love their business and that it is essentially their life, so it would not be wise to discuss an exit strategy at this time. However, you do believe that their asset allocation needs serious adjustment and want to propose that they make fundamental changes in their portfolio. By focusing all of their funds in a large cap growth fund, the Sachses are not diversified and could sustain a substantial loss if the market for large cap stocks were to decline and they needed to liquidate the shares. In addition, since they have no retirement accounts, they are missing an opportunity to reduce current federal income taxes. Exhibit $1$ provides a correlation matrix for several ETFs and historical returns on the indexes they track.

Exhibit $1$ Correlation Coefficients Relating Returns for Selected ETFs

$\backslash$table$[[,\backslash$table$[[$Large$],[$Cap$]],\backslash$table$[[$Small$],[$Cap$]],\backslash$table$[[$Corporate$],[$Bonds$]],\backslash$table$[[$Money$],[$Market$]],\backslash$table$[[$Real$],[$Estate$]],\backslash$table$[[$Foreign$],[$Stocks$]],$Ri$],[$Large cap,$1\mathrm{.}00,,,,,,],[$Small cap,$0\mathrm{.}78,1\mathrm{.}00,,,,,],[\backslash$table$[[$Corporate$],[$bonds$]],0\mathrm{.}23,0\mathrm{.}12,1\mathrm{.}00,,,,],[\backslash$table$[[$Money$],[$market$],[$securities$]],0\mathrm{.}10,0\mathrm{.}05,0\mathrm{.}65,1\mathrm{.}00,,,],[\backslash$table$[[$Real$],[$estate$]],0\mathrm{.}26,0\mathrm{.}35,0\mathrm{.}14,0\mathrm{.}03,1\mathrm{.}00,,],[\backslash$table$[[$Foreign$],[$stocks$]],0\mathrm{.}35,0\mathrm{.}26,0\mathrm{.}17,0\mathrm{.}14,0\mathrm{.}28,1\mathrm{.}00,1]]$

Based on the information in Exhibit $1,$ you must develop a simple illustration of asset allocation that uses a variety of investment companies and encompasses the following questions and considerations:

What differentiates an ETF from other investment companies? How easily are ETF shares bought and sold? Do they sell for a premium or discount from their NAVs?

What are the tax implications if the Sachses sell the stock they currently hold to obtain funds to invest in other alternatives?

Should Eva and Walther open a retirement account? Which of the various ETFs may be the most appropriate to acquire in a retirement account?

Develop an illustrative allocation. $($Express the allocation in both dollars and percentages.$)$ What is the purpose of each component of your allocation?

What is the importance of the correlation coefficients between the returns?

Assume that the cost basis of the current large cap mutual fund is $$250,000.$ If the returns in Exhibit $1$ are maintained, how much will the portfolio be worth after $10$ years? Has the asset allocation changed and, if so$,$ what steps may be taken?

Based on your answers to the aforementioned questions, what course$($s$)$ of action do you suggest that Eva and Walther Sachs take?