soln_ch_26_portf_mgt

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CHAPTER 26: MANAGING CLIENT PORTFOLIOS

1. a. An appropriate investment policy statement for the endowment fund will be organizedaround the following major, specific aspects of the situation:

1. The primacy of the current income requirement!. The inability to accept significant ris" as to #$% of the original capital&. The 1'(year time horizon present within the fund)s infinite life span*. The unique and dominating circumstance represented by the +une &', 1#, capital

payout requirement and$. The requirements of the -spending rule.-

-The endowment fund)s investment assets shall be managed in a rudent /an conte0t toprovide a total return of at least #% per year, including an original $'',''' 2$%3 currentincome component growing at &% annually. /eeting this current income goal is the primaryreturn objective. 4nasmuch as #,$'',''' of capital must be distributed in cash on +une &',1#, no significant ris" can be ta"en on whatever sum is required to guarantee this payouta normal ris" capacity shall be assumed with respect to remaining investment assets. Thefund)s horizon is very long term as to assets not required for the 1# distribution. The4nvestment 5ommittee)s )spending rule) shall be ta"en into account in determining investmentstrategy and annual income distributions.-

b. The account circumstances will affect the initial asset allocation in the following major ways:1. The aggregate portfolio will have much larger than normal holdings of 6.7. Treasury

and Treasury(related securities. /a0imum use of discount Treasuries and relatedzero(coupon securities will be made to minimize the ris" and the amount of totalassets that must be -frozen- in order to assure the availability of #,$'',''' on +une&', 1#.

!. The aggregate portfolio will have much smaller than normal holdings of equitysecurities, given the need to -loc" up- the 1# distribution requirement in virtuallyris"less form. The initial mi0 here might well be 1$% zeros, $$% discountTreasuries, and only &'% equities in a normal situation, 8'(9'% in equities wouldnot be uncommon.

&. The equity portfolio will emphasize a growth orientation. 0cess income over thecurrent income requirement will be added to equity. ;ot only must building offuture value and income come from the rather small equity component of theportfolio, but it must also serve an inflation protection need as well. 7ince it doesnot appear that meeting the annual current income target will be difficult initially,there is plenty of room for lower(yielding issues to be included in the equity mi0.

*. The aggregate portfolio ris" level will be well below average. The 1# payoutrequirement dictates a zero ris" posture on a large part of the total, while therudent /an environment will act to prevent overzealous ris"(ta"ing in the-remainder- portion.

$. The fund)s ta0 e0empt status ma0imizes allocation fle0ibility, both as to incomeaspects and as to planning for future capital growth.

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8. A 1'(year horizon must be accommodated as to a major portion of total capitalfunds, while a very long term horizon applies to the rest.

!. c. igh income bond fund

8. a. An approach to asset allocation that ?77 could use is the one detailed in the chapter. 4tconsists of the following steps:1. 7pecification of the asset classes to be included in the portfolio. The major classes

usually considered are:. /oney mar"et instruments 2usually called cash3. @i0ed income securities 2usually called bonds3

. 7toc"s

. eal estate

. recious metals

. =ther !. 7pecify capital mar"et e0pectations. This step consists of using both historical data

and economic analysis to determine your e0pectations of future rates of return overthe relevant holding period on the assets to be considered for inclusion in theportfolio.

&. Berive the efficient portfolio frontier. This step consists of finding portfolios thatachieve the ma0imum e0pected return for any given degree of ris".

*. @ind the optimal asset mi0. This step consists of selecting the efficient portfolio that

best meets your ris" and return objectives while satisfying the constraints you face.

b. A guardian investor typically is an individual who wishes to preserve the purchasing powerof his assets. 0treme guardians would be e0clusively in AAA short term credits. ?77should first determine how long the time horizon is and how high the return e0pectationsare. Assuming a long horizon and #(1'% return 2preta03 e0pectations, the portfolio couldbe allocated &'(*'% bonds, &'(*'% stoc"s, and modest allocations to the other assetgroups.

9. a. 2i3 Cey constraints are important in developing a satisfactory investment plan in ?reenDs situation, asin all investment situations. 4n particular, those constraints involving investment horizon,liquidity, ta0es, and unique circumstances are especially important to ?reen. >is investmentpolicy statement fails to provide an adequate treatment of the following "ey constraints:

1. Horizon.At age 8& and enjoying good health, ?reen still has an intermediate to long investment horizon ahead. Ehen considered in the light of his wish to pass his wealth

onto his daughter and grandson, the horizon e0tends further. Bespite his apparent personal

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orientation toward short(term income considerations, planning should reflect a long(term approach.

!. Liquidity.Eith spending e0ceeding income and cash resources down to 1',''', ?reen is about to e0perience a liquidity crisis. >is desire to maintain the present spending level requires reorganizing his financial situation. This may involve using some capital and reconfiguring his investment assets.

&. Ta !on"id#ration".?reenDs apparent neglect of this factor is a main cause of his cash squeeze and requires prompt attention as part of reorganizing his finances. >e should get

professional advice and adopt a specific ta0 strategy. 4n the 6nited 7tates, such a strategy should include using municipal securities and possibly other forms of ta0 shelter.

*. $niqu# !ir!u%"tan!#".?reenDs desire to leave a 1,''',''' estate to benefit his daughterand grandson is a challenge whose effects are primary to reorganizing his finances. Again,

the need for professional advice is obvious. The form of the legal arrangements, fore0ample, may determine the form the investment ta"es. ?reen is unli"ely to accept

any investment advice that does not address this e0pressed goal.

Otr !on"traint". Three other constraints are present. @irst, ?reen does not mention theneed to protect himself against inflationDs effects. 7econd, he does not appear to realize the

inherent contradictions involved in saying he needs a Fma0imum returnG with an income element large enough to meet his considerable spending needs. >e also wants Flow ris",G a minimum Fpossibility of large lossesG and preservation of the 1,''',''' value of his investments. Third, his statements are unclear about whether he intends to leave 1,''',''' or some larger sum that would be the inflation(adjusted future equivalent of todayDs

1,''',''' value.

2ii3 Appropriate return and ris" objectives for ?reen are as follows:

R#turn. 4n managing ?reenDs portfolio, return emphasis should reflect his need forma0imizing current income consistent with his desire to leave an estate at least equalto the 1,''',''' current value of his invested assests. ?iven his inability to reducespending and his constraining ta0 situation, this may require a total return approach.

To meet his spending needs, ?reen may have to supplement an insufficient yield in certain years with some of his investment gains. >e should also consider inflation protection and a

specific ta0 strategy in determining asset allocation. These are important needs in this situation given the intermediate to long investment horizon and his estate(disposition plans.

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Ri"'. ?reen does not appear to have a high tolerance for ris", as shown by his concernabout capital preservation and the avoidance of large losses. Het, he should have a moderate

degree of equity e0posure to protect his estate against inflation and to provide growth inincome over time. A long time horizon and the size of his assets reflect his ability to accept

such ris". >e clearly needs counseling in this area because the current ris" level is too high given his preferences.

b. 2i3 The following shows the calculation of the e0pected total return associated with the fund for each of the two different asset mi0es, given the three scenarios in Table !.

The following table shows projected returns in each economic scenario. The FBegearingGscenario is for a stable economic environment: economic growth is !.$ percent a year and the

inflation rate is &.' percent. This scenario provides positive returns for all three assetclasses, and stoc"s outperform both bonds and Treasury bills. The other two scenarios ((

FBisinflationG and F4nflationG(( posit less stable conditions in which stoc"s do poorly.Ionds also generate losses in the F4nflationG scenario, but provide considerable downside

protection under FBisinflationG conditions.

The calculations for the multiple scenario analysis 2see below3 show that of the three assetclasses, bonds offer the highest e0pected real return, !.!$ percent, over the forecast horizon.

=ver the same horizon, stoc"s are projected to generate a negative real return of ('.1!$ percent. 7toc"s are adversely affected in the FBisinflationG scenario and also show losses under the F4nflationG scenario. ?iven the probabilities assigned to the three scenarios, the stoc"JbondJcash mi0 of *'J*'J!' provides a superior real return 21.1' percent3 to that from the alternative 8'J&'J1' mi0 2'.9& percent3. This analysis reveals that equities do not

automatically produce the highest e0pected returns even when the most li"ely economic scenario is for a stable environment accompanied by slow growth. 4f other less favorable outcomes have a reasonable probability of occurring, higher equity e0posures may not

produce a commensurately higher return. The multiple scenario forecasting methodologyprovides a valuable tool for effectively e0ploring the impact of various possibilities via a

Fwhat ifG approach.

eal Total eturnsBegearing Bisinflation 4nflation 0pected eturn

T(bills 21.$' '.$3 K 2 1.$ '.!$3 K 2 '.$ '.!$3 L 1.!$'%

Ionds 2&.!$ '.$3 K 2 8.$ '.!$3 K 2(*.' '.!$3 L !.!$'

7toc"s 2$.!$ '.$3 K 2(.' '.!$3 K 2(!.' '.!$3 L '.1!$

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eal ortfolio eturns*'J*'J!' /i0 8'J&'J1' /i0

T(bills 1.!$' '.! L '.!$% 1.!$' '.1 L '.1!$%

Ionds !.!$' '.* L .' !.!$' '.& L '.89$

7toc"s '.1!$ '.* L ('.'$ '.1!$ '.8 L ('.'9$

Total 1.1'% '.9!$%

An alternate calculation approach is set forth below. This approach involves finding theportfolio returns under each scenario and then finding the final e0pected returns using theprobabilities:

R#a( R#turn )*+)*+2* Mi

Begearing: 2$.!$ 0 '.*'3 K 2&.!$ 0 '.*'3 K 21.$ 0 '.!'3 L &.9%Bisinflation: 2(.'' 0 '.*'3 K 28.$' 0 '.*'3 K 21.$ 0 '.!'3 L ('.94nflation: 2(!.'' 0 '.*'3 K 2(*.'' 0 '.*'3 K 2'.$ 0 '.!'3 L (!.&

0pected eturn L M2&.9% 0 '.$3 K 2('.9% 0 '.!$3 K 2(!.&% 0 '.!$3N L 1.1%

The same alternate procedure applies to the 8'J&'J1' mi0.

2ii3 ,u"ti-i!ation:The answer to part 2i3 provides much of the justification for the @undDs *'J*'J!' asset mi0. ?iven the three economic scenarios, each having a reasonable chance of occurring,

the e0pected portfolio real returns are 1.1' percent for the e0isting mi0 versus '.9!$ percent forthe 8'J&'J1' mi0. Therefore, the *'J*'J!' mi0 is superior. Although using the scenarios mayfail to capture subsequent events, the *'J*'J!' mi0 provides the lowest ris" e0posure. Thereturn superiority, if any, represents added value. erversely, the more stoc"s in the portfolio,the worse the outcomes under the circumstances captured by the scenarios.

E(anation: The e0planation, also captured in the answer to art 2i3, lies primarily in the fact that stoc"s generate losses in both the FBisinflationG and the F4nflationG scenarios. 4ncreasingthe proportion in stoc"s increases the portfolioDs e0posure to their relatively poor performance.Ionds offer the highest e0pected real returns over the investment horizon, followed by cash

equivalents such as Treasury bills, whose return is positive under each scenario. 7toc"sDsuperiority of returns under the FBegearingG scenario is insufficient, even with that scenariogiven a '.$' probability of occurring, to overcome the FBisinflationG outcome for that assetclass.

2iii3 ?reenDs "ey needs are:

1. a portfolio offering a long horizon,

!. ta0 awareness 2if not ta0 shelter3, &. control over the timing of gain realization, *. an emphasis on production of current income,

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$. a smooth and dependable flow of investment income and, 8. a below(average ris" level, especially as to the possibility of large losses.

?reen owns no real estate, receives no private pension income, and has only a small,ta0able government benefit payment. >e also has no major noninvestment resources

and depends entirely on his investment income for his spending. >e does not intend to reduce his spending level. ?reen hopes to leave his present worth to his daughter and grandson for

their future financial protection. These factors provide the bac"ground for evaluating theappropriateness of the @und as a primary investment asset.

4n the @undDs favor are the following positive characteristics:

1. /i0#r"i-yin1 a1#nt. 4f the @und were part of a portfolio rather than ?reenDs onlyinvestment, it would serve as an e0cellent diversifying agent.

!. Ad#quat# r#turn. ?reen has owned the @und shares for si0 years, over which period 2via distributions of both income and gains3 he has realized an average annual return

of about #% a year and has also recorded a 1'',''' unrealized gain from @und valuegrowth beyond the distributions. This is an average but a satisfactory result.

&. Con"#r0ati0# ori#ntation. Iased on a scenario e0ercise and the e0isting *'J*'J!' asset allocation, the @undDs management team appears to have a conservative orientation, which meets ?reenDs e0pressed preference.

Bespite the positive aspects of the @und, most of the evidence suggests that the @und is inappropriate as a primary investment asset for ?reen for the following reasons:

1. Ri"'y "trat#1y to a!&i#0# Gr##n" 1oa(". The Fall eggs in one bas"et,G single(asset

nature of ?reenDs investment is a high(ris" strategy, which is clearly inappropriate to ?reenDs circumstances. The $$ percent out(of(6.7. e0posure ?reen holds via the @und appears e0cessive compared with any "nown needs or goals.

!. Nonoti%a( a""#t %i o- Fund -or Gr##n. Although the @undDs broad globaldiversification might ma0imize return and minimize volatility with respect to it ownparticular asset allocation, its composition is unli"ely to meet ?reenDs comple0 set of

specific return needs. The asset mi0 that is optimal for the @und is not necessarily optimal for ?reen.

&. E!#""i0# 3o(ati(ity. /uch of the distribution flow from the @und depends on capital gains. ?iven ?reenDs spending pattern, the volatility of this flow is li"ely to be e0cessive in terms

of ?reenDs needs for income stability and dependability.

*. La!' o- -o!u" on a-t#r4ta r#turn" and !ontro(. The @undDs management focuses on producing total returns, but ?reenDs need is for ma0imum after(ta0 returns and for some

control over the timing of gain realizations. 6nder present circumstances, gain realizations

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are random, uncontrollable events for ?reen, who must pay ta0es on the gain distributions as they occur.

$. La!' o- -o!u" on in!o%# n##d". The @und cannot give the single(minded attention toincome type, amount, regularity, and ta0 nature that this aspect of ?reenDs situation needs.

8. In-(ation. The global nature of the @undDs investment means that inflation in the 6nited7tates, which affects ?reen directly, probably does not get the concentrated attention that

planning for ?reen must give it.

=n balance, the @und is not an appropriate primary investment for ?reen, e0cept as adiversifying piece of a much larger, balanced portfolio.

c. Bescription of Adjustment

1. Hi"tori!a( r#a( int#r#"t rat#. The historical real interest rate should be adjusted to removedistortion caused by the 6.7. governmentDs FpeggingG of interest rates at artificially low

levels in the 1*'s and early 1$'s, when Treasury(bill rates averaged a '.$& percent return 21*1($'3. 4f the government had not pegged interest rates during this period, the rate probably would have been higher than observed, and the FtrueG long(term average rates

would be higher. This situation suggests an upward adjustmentto historical real interestrates.

!. 5ond %aturity r#%iu%. The observed bond maturity premium should be adjusted toremove bias caused by the pronounced upward trend in inflation and nominal interest rates

during the period 1!8(#9, when investors systematically e0perienced capital losses on long( term bond holdings. Therefore, an upward adjustmentto the historical long(term bond

maturity premium is also indicated to remove the bias.

,u"ti-i!ation: The justification for each of these adjustments is that the data containsystematic, long(lasting artificial biases. 7uch biases must be removed if these data items are tobe useful for forming valid e0pectations.

d. Adjustments are justified when e0isting or prospective circumstances relating to the economicor mar"et factors to be considered differ from those reflected in the historical data. Ceycircumstances to consider when forming e0pectations about future returns are:

1. Curr#nt yi#(d !ur0# and rat# o- in-(ation. 4n deriving e0pected returns, an investor mightadjust the historical returns of different asset classes to consider the current yield curve and

inflation rate. =ver time, prospective returns may converge on historical e0perience, but the e0pectations embedded in current data must also be considered in deriving best e0pectations

of the future.

!. Ha(o7 or %ar'do8n #--#!t. A halo effect may develop around an asset class that hasdone unusually well over a prolonged period, resulting in a historical record needing

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adjustment. /ar"et participants do not easily forget bad investment e0perience with aparticular asset class. Therefore, investors might want to adjust historical returns on anasset class that has done badly over a prolonged period to eliminate any embedded bias.

&. /i"tin!t #riod. The historical return data since 1!8 include many distinct eras withdifferent capital mar"et and inflation e0periences. An investor might want to reflect thepossibility that the forecast period might differ substantially from the historical norm ormight closely resemble a subperiod.

*. N#8 di%#n"ion" in #n0iron%#nt. The environment of todayDs capital mar"ets hasdimensions to it such that history may be of little use. These dimensions include thesavingsJinvestment and importJe0port disequilibria in the 6.7. economy, the globalizationand integration of capital mar"ets, and rapid innovation in financial instruments. Aninvestor may want to consider these dimensions in forecasting future returns.

$. /i--#r#nt 1ro8t& ro"#!t". 4f the economic growth prospects today differ fromhistorical growth e0perience, an investor should consider this circumstance when forming

e0pectations about future returns.

8. $na0ai(a9i(ity o- !o%(#t# or !o%ara9(# data. The lac" of availability of complete or comparable data on a given asset class 2e.g., real estate, venture capital, and non(6.7.

investments3 does not justify ignoring them. An investor might use available results plus"nowledge of the ris"Jreturn characteristics of that asset class to derive useful e0pectedreturn data and, thus, include that class in the universe of available asset classes.

9. Lin' 9#t8##n ri"' to(#ran!# and 0a(u# o- !aita( a""#t". 7harpe points out that a directlin" e0ists between the collective ris" tolerance of investors and the per capita value ofcapital assets. An increase in this measure should cause ris" premia 2maturity, default,

equity3 to decline, and vice versa. An investor who believes mar"et participants have not considered this may want to adjust historical ris" premia appropriately.

#. a. An 4nvestment olicy 7tatement for @airfa0 based onlyon the information provided in the4ntroduction is shown below.

Overview. @airfa0 is $# years old and has seven years until a planned retirement. 7he hasa fairly lavish lifestyle but few money worries. >er large salary pays all current e0penses,and she has accumulated ! million in cash equivalents from savings in previous years.>er health is e0cellent, and her health insurance coverage will continue after retirementand is employer paid. Ehile @airfa0Ds job is a high(level one, she is not well versed ininvestment matters and has had the good sense to connect with professional counsel to getstarted on planning for her investment future, a future that is complicated by ownership ofa 1' million bloc" of company stoc" that while listed on the ;H7, pays no dividendsand has a zero(cost basis for ta0 purposes. All salary, investment income 2e0cept intereston municipal bonds3, and realized capital gains are ta0ed to @airfa0 at a &$ percent ratethis rate and a * percent inflation rate are e0pected to continue into the future. @airfa0

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would accept a & percent real, after(ta0 return from the investment portfolio to be formedfrom her ! million in savings 2Fthe 7avings ortfolioG3 if that return could be obtainedwith only modest portfolio volatility 2i.e., less than a 1' percent annual decline3. 7he isdescribed as being conservative in all things.

Objectives

R#turn R#quir#%#nt. @airfa0Ds need for portfolio income begins seven years from now, at

the date of retirement. The investment focus for her 7avings ortfolio should be ongrowing the portfolioDs value in the interim in a way that provides protection against loss ofpurchasing power. >er &% real, after(ta0 return preference implies a gross total returnrequirement of at least 1'.# percent, assuming her investments are fully ta0able 2as is thecase now3 and assuming *% inflation and a &$ percent ta0 rate. @or @airfa0 to maintain her

current lifestyle, she would have to generate $'',''' 21.'*39or 8$#,''', in annual

income, inflation adjusted, when she retires. 4f the mar"et value of estonDs stoc" does not

change, and if she is able to earn a 1'.#% return on the 7avings ortfolio 2or 9% nominalafter(ta0 return L !,''',''' 21.'93

9L &,!11,$''3 she should accumulate 1&,!11,$''

by retirement age. To generate 8$#,''', a return on 1&,!11,$'' of $.' percent would beneeded.

Ri"' To(#ran!#. @rom the information provided, @airfa0 is quite ris" averse, indicating

she does not want to e0perience a decline of more than 1'% in the value of the 7avingsortfolio in any given year. This would indicate that the portfolio should have belowaverage ris" e0posure to minimize its downside volatility. 4n terms of overall wealth, shecould afford to ta"e more than average ris", but because of her preferences and thenondiversified nature of the total portfolio, a below(average ris" objective is appropriate

for the 7avings ortfolio. 4t should be noted, however, that truly meaningful statementsabout the ris" of @airfa0Ds total portfolio are tied to assumptions about the volatility ofestonDs stoc", if it is retained, and about when and at what price the eston stoc" will besold. Iecause the eston holding constitutes #&% of @airfa0Ds total portfolio, it willlargely determine the ris" she actually e0periences as long as it remains intact.

Constraints

Ti%# Horizon. Two time horizons are applicable to @airfa0Ds life. The first time horizon

represents the period during which @airfa0 should set up her financial situation inpreparation for the balance of the second time horizon, her retirement period of indefinitelength. =f the two horizons, the longer term to the e0pected end of her life is the dominanthorizon because it is over this period that the assets must fulfill their primary function offunding her e0penses, in an annuity sense, in retirement.

Liquidity. Eith liquidity defined either as income needs or as cash reserves to meet

emergency needs, @airfa0Ds liquidity requirement is minimal. $'',''' of salary is available

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annually, health cost concerns are none0istent, and we "now of no planned needs for cashfrom the portfolio.

Ta#". @airfa0Ds ta0able income 2salary, ta0able investment income, and realized capital

gains on securities3 is ta0ed at a &$ percent rate. 5areful ta0 planning and coordination with

investment planning is required. 4nvestment strategy should include see"ing income that issheltered from ta0es and holding securities for lengthy time periods to produce larger after(ta0(returns. 7ale of the eston stoc" will have sizeable ta0 consequences because @airfa0Dscost basis is zero special planning will be needed for this. @airfa0 may want to considersome form of charitable giving, either during her lifetime or at death. 7he has no immediatefamily, and we "now of no other potential gift or bequest recipients.

La8" and R#1u(ation". @airfa0 should be aware of and abide by any securities 2or other3

laws or regulations relating to her FinsiderG status at eston and her holding of estonstoc". Although there is no trust instrument in place, if @airfa0Ds future investing is handledby an investment advisor, the responsibilities associated with the rudent erson ule willcome into play, including the responsibility for investing in a diversified portfolio. Also, shehas a need to see" estate planning legal assistance, even though there are no apparent gift orbequest recipients.

$niqu# Cir!u%"tan!#" and+or Pr#-#r#n!#". 5learly, the value of the eston stoc"

dominates the value of @airfa0Ds portfolio. A well(defined e0it strategy needs to bedeveloped for the stoc" as soon as is practical and appropriate. 4f the value of the stoc"increases, or at least does not decline before it is liquidated, @airfa0Ds present lifestyle canbe maintained after retirement with the combined portfolio. A significant and prolongedsetbac" for eston 4ndustries, however, could have disastrous consequences. 7uchcircumstances would require a dramatic downscaling of @airfa0Ds lifestyle or generation ofalternate sources of income to maintain her current lifestyle. A worst(case scenario mightbe characterized by a $'% drop in the mar"et value of estonDs stoc" and sale of thatstoc" to diversify the portfolio, where the sale proceeds would be subject to a &$% ta0

rate. The net proceeds of the eston part of the portfolio would be 1',''',''' .$ 21

.&$3 L &,!$','''. Ehen added to the 7avings ortfolio, total portfolio value would be

$,!$','''. @or this portfolio to generate 8$#,''' in income, a 1!.$% return would berequired.

Synopsis. The policy governing investment in @airfa0Ds 7avings ortfolio shall putemphasis on realizing a &% real, after(ta0 return from a mi0 of high(quality assets with lessthan average ris". =ngoing attention shall be given to @airfa0Ds ta0 planning and legalneeds, her progress toward retirement, and the value of her eston stoc". The estonstoc" holding is a unique circumstance of decisive significance in this situation.Bevelopments should be monitored closely, and protection against the effects of a worst(case scenario should be implemented as soon as possible.

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b. A critique of the 5oastal Advisors proposal, created for investment of the 7avingsortfolio, including three wea"nesses related to the 4nvestment olicy 7tatement in art a,follows.

Critique. The 5oastal proposal produces a real, after(ta0 e0pected return of about $.1#%,which e0ceeds the &% level sought by @airfa0. The e0pected return of the proposal can becalculated by subtracting the ta0(e0empt yield from the total current yield:

*.% .$$% L *.&$%

and converting this to an after(ta0 yield:

*.&$% 21 .&$3 L !.#&%

The ta0 e0empt income is then added bac" in:

!.#&% K .$$% L &.%

The appreciation portion of the return 2$.#%3 is then added to the after(ta0 yield to get thenominal portfolio return:

&.% K $.#'% L .1#%

@inally, the *% inflation factor is subtracted to produce the e0pected real after(ta0 return:

.1#% O *.'% L $.1#%

This result can also be obtained by determining these calculations for each of the

individual holdings, weighting each result by the portfolio percentage and then adding to atotal portfolio result.

@rom the data available, it is not possible to determine specifically the inherent degree ofportfolio volatility. Bespite meeting the return criterion, the allocation is neither realisticnor, in its detail, appropriate to @airfa0Ds situation in the conte0t of an investment policyusefully applicable to her. The primary wea"nesses are the following:

A((o!ation o- Equity A""#t". 0posure to equity assets will be necessary to achieve the

return requirements of @airfa0 however, greater diversification of these assets amongother equity classes is needed to produce a more efficient, potentially less volatile

portfolio that would meet her ris" tolerance parameters as well as her returnrequirements. An allocation that focuses the equity investments in 6.7. large-capandJorsmall-capholdings and includes smaller international and eal state 4nvestment Truste0posure is more li"ely to achieve the return and ris" tolerance goals. 4f moreinformation were available concerning the returns and volatility of the eston stoc", an

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argument could be made that this holding is the 6.7. equity component of her portfolio.Iut the lac" of this information precludes ta"ing it into account for the 7avings ortfolioallocation and creates the need for broader equity diversification.

Ca"& a((o!ation. Eithin the proposed fi0ed(income component, the 1$% allocation to

cash is e0cessive given the limited liquidity need and the low returns the asset classoffers.

Cororat#+Muni!ia( 5ond A((o!ation. The corporate bond allocation 21' percent3 is

inappropriate given @airfa0Ds ta0 situation and the superior after(ta0 yield on municipalbonds relative to corporate 2$.$% vs. *.%3.

3#ntur# Caita( A((o!ation. The allocation to venture capital is questionable given

@airfa0Ds policy statement which reveals that she is quite ris" averse. Although venturecapital may provide diversification benefits, venture capital returns historically have beenmore volatile than other ris"y assets such as large( and small(cap stoc"s in the 6nited

7tates. >ence, even a small percentage allocation to venture capital may beinappropriate.

La!' o- Ri"'+3o(ati(ity In-or%ation. The proposal concentrates on return

e0pectations and ignores ris"Jvolatility implications. 7pecifically, the proposal shouldhave addressed the e0pected volatility of the entire portfolio to see if it falls within theris" tolerance parameters of @airfa0.

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c. 2i3 @airfa0 has stated that she is see"ing a & percent real, after(ta0 return. Table !8 providesnominal, pre(ta0 figures, which must be adjusted for both ta0es and inflation to ascertainwhich portfolios meet @airfa0Ds return objective. A simple solution is to subtract themunicipal bond return component from the stated return, then subject the resulting figure toa &$ percent ta0 rate, and add bac" ta0(e0empt municipal bond income. This produces anominal, after(ta0 return. Then subtract * percent inflation to arrive at the real, after(ta0return. @or e0ample, Allocation A has a real after(ta0 return of &.* percent, calculated as:

M.' O 2.'9!3 0 2.*3N 0 M1(.&$N K M2.'9!3 0 2.*3N O M.'*N L &.**%

Alternatively, it can be calculated by multiplying the ta0able returns by their allocations,summing these products, adjusting for the ta0 rate, adding the result to the product of thenonta0able 2municipal bond3 return and its allocation, and deducting the inflation rate fromthis sum. @or Allocation A,

2.'*$3 0 2.1'3 K 2.1&3 0 2.!3 K 2.1$3 0 2.13 K 2.1$3 0 2.13 K 2.13 0 2.13N 0 M1 ( .&$N KM2.'9!3 0 2.*3N O M.'*N L &.*8%

Allocation

Return Measure A B C D E

;ominal eturn .% 11.'% #.#% 1*.*% 1'.&%

eal After(Ta0 eturn &.$% &.1% !.$% $.&% &.$%

Table !8 also provides after(ta0 returns that could be adjusted for inflation and then used

to ascertain the portfolios that meet @airfa0Ds return guidelines.

Allocations A, I, B, and meet @airfa0Ds real, after(ta0 return objectives.

2ii3 @airfa0 has stated that a worst case return of O1' percent in any 1!(month period wouldbe acceptable. The e0pected return less two times the portfolio ris" 2e0pected standarddeviation3 is the relevant ris" tolerance measure. 4n this case, three allocations meet thecriterion: A, 5, and .

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Allocation

Para%#t#r A 5 C / E

0pected eturn .% 11.'% #.#% 1*.*% 1'.&%

0p. 7td. Beviation .*% 1!.*% #.$% 1#.1% 1'.1%

Eorst 5ase eturn #.% 1&.#% #.!% !1.#% .%

d. i. The 7harpe atio for Allocation B, using the cash equivalent rate of *.$ percent as the

ris"(free rate, is 2.1** .'*$3J.1#1 L .$*9.

ii. The two allocations with the best 7harpe atios are A and with ratios of '.$9* each.

e. The recommended allocation is A. The allocations that meet both the minimum real, after(

ta0 objective and the ma0imum ris" tolerance objective are A and . These allocationshave identical 7harpe atios. Ioth allocations have large e0posures to municipal bonds.Iut Allocation also has a large position in 4T stoc"s, whereas Allocation ADscounterpart large equity allocation is to a diversified portfolio of large and small capdomestic stoc"s. Iecause of the diversification value of the large and small stoc"representation in A as opposed to the specialized or nondiversified nature of 4T stoc"sand their limited data history, there can be more confidence that the e0pectational data forthe large( and small( cap stoc" portfolios will be realized than for the 4T portfolio.

. a. The "ey elements that should determine the foundationDs grant(ma"ing 2spending3 policyare:

1. Average e0pected inflation over a long horizon!. Average e0pected nominal return on the endowment portfolio over the same long

horizon and&. The $%(of(asset(value payout requirement imposed by the ta0 authorities as a

condition for ongoing 6.7. ta0 e0emption, a requirement that is e0pected to continueindefinitely.

To preserve the real value of its assets and to maintain its spending in real terms, thefoundation cannot pay out more, on average over time, than the real return it earns fromits investment portfolio, since no fund(raising activities are contemplated. 4n effect, theportion of the total return representing the inflation rate must be retained and reinvested if

the foundationDs principal is to grow with inflation and, thus, maintain its real value andthe real value of future grants.

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b. Objectives

eturn equirement: roduction of current income, the committeeDs focus before /r.@ran"linDs gift, is no longer a primary objective, given the increase in the asset base and the5ommitteeDs understanding that investment policy must accommodate long(term as well asshort(term goals. The need for a minimum annual payout equal to $% of assets must beconsidered, as well as the need to maintain the real value of these assets. A total returnobjective 2roughly equal to the grant rate plus the inflation rate, but not less than the $%required for maintenance of the foundationDs ta0(e0empt status3 is appropriate.

is" Tolerance: The increase in the foundationDs financial fle0ibility arising from /r.@ran"linDs gift and the committeeDs spending policy change have increased the foundationDsability to assume ris". The organization has a more or less infinite e0pected life span and,in the conte0t of this long(term horizon, has the ability to accept the consequences ofshort(term fluctuations in asset values. /oreover, adoption of a clear(cut spending rulewill permit cash flows to be planned with some precision, adding stability to annualbudgeting and reducing the need for precautionary liquidity. =verall, the foundationDs ris"

tolerance is above average and oriented to long(term considerations.

Constraints


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c. To meet requirements of this question, it is first necessary to identify a spending rate that isboth sufficient 2i.e., $% or higher in nominal terms3 and feasible 2i.e., prudent andattainable under the circumstances represented by the Table !8@ data and the empiricalevidence of historical ris" and return for the various asset classes3. The real return fromthe recommended allocation should be shown to equal or e0ceed the minimum payoutrequirement 2i.e., equal to or greater than $% in nominal terms3.

The allocation philosophy will reflect the foundationDs need for real returns at or above thegrant rate, its total return orientation, its above average ris" tolerance, its low liquidityrequirements, and its ta0 e0empt status. Ehile the Table !8@ data and historicale0perience provide needed inputs to the process, several generalizations are alsoappropriate:

1. Allocations to fi0ed income instruments will be less than $'% as bonds haveprovided inferior real returns in the past, and while forecasted real returns from1& to !''' are higher, they are still lower than for stoc"s. eal return needs arehigh and liquidity needs are low. Ionds will be included primarily for

diversification and ris" reduction purposes. The ongoing cash flow from bondportfolios of this size should easily provide for all normal wor"ing capital needs.

!. Allocations to equities will be greater than $'%, and this asset class will be theportfolioDs F wor" horse asset.G 0pected and historical real returns are high, thehorizon is long, ris" tolerance is above average, and ta0es are not a consideration.

&. Eithin the equity universe there is room in this situation for small cap as well aslarge cap issues, for international as well as domestic issues and, perhaps, forventure capital investment as well. Biversification will contribute to ris"reduction, and total return could be enhanced. All could be included.

*. ?iven its value as an alternative to stoc"s and bonds as a way to maintain realreturn and provide diversification benefits, real estate could be included in thisportfolio. 4n a long term conte0t, real estate has provided good inflationprotection, helping to protect real return production.

An e0ample of an appropriate, modestly aggressive allocation is shown below. Table!8@ contains an array of historical and e0pected return data which was used to developreal return forecasts. 4n this case, the objective was to reach a spending level in realterms as close to 8% as possible, a level appearing to meet the dual goals of thecommittee and that is also feasible. The actual e0pected real portfolio return is $.#%.

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4ntermediate(term @orecast ecommendedeal eturnAsset 5lass of eal eturns Allocation 5ontribution

5ash 26.7.3T(bills '.9% P'%

Ionds:4ntermediate !.& $ .11$%


18/35

available on the 7 R $'' 4nde0 and on Treasury bonds, notes, and bills. ;o cashoutlay would be required. 4nstead, the foundation could use some of its currentportfolio as a good faith deposit or FmarginG to ta"e the long positions. Themar"et value of the futures contracts will, in general, mirror changes in theunderlying mar"et values of the 7R $'' 4nde0 and Treasuries. Although noimmediate cash outlay is required, any gains 2losses3 in the value of the contractswill be added to 2subtracted from3 the margin deposit daily. >ence, if mar"etsadvance as the committee e0pects, the balances in the foundationDs futures accountshould reflect the mar"et increase.

b. There are both positive and negative factors to be considered in hedging the '(day gapbefore the e0pected receipt of the @ran"lin gift.

POSITI3E FACTORS

1. The foundation could establish its position in stoc" and bond mar"ets usingderivatives to benefit from any subsequent increases in mar"et values in the 7 R

4nde0 and Treasury instruments in the '(day period. 4n effect, the foundationwould have a synthetic position in those mar"ets beginning today.

!. The cost of establishing the synthetic position is relatively low, depending on thederivative strategy used. 4f calls are used, the cost is limited to the premiums paid.4f futures are used, the losses on the futures contracts would be similar to theamounts that would be lost if the foundation invested the gift today. Eriting theputs is the ris"iest strategy because there is an open(ended loss if the mar"etdeclines, but here again the losses would be similar if the foundation invested todayand stoc" and bond mar"ets declined.

&. Berivative mar"ets 2for the types of contracts under consideration here3 are liquid.

NEGATI3E FACTORS

1. The @ran"lin gift could be delayed or not received at all. This would create asituation in which the foundation would have to unwind its position and coulde0perience losses, depending on mar"et movements in the underlying assets.

!. The committee might be wrong in its e0pectation that stoc" and bond prices willrise in the '(day period. 4f prices decline on stoc"s and bonds, the foundationwould lose part or all of the premium on the calls and have losses on the futurescontracts and the puts written. The ris" of loss of capital is a serious concern.2?iven that the current investment is primarily bonds and cash, the foundation maynot be "nowledgeable enough to forecast stoc" prices over the ne0t ' days.3

&. Iecause there is a limited choice of options and futures derivative contractscompared to the universe that the committee might wish to invest in, there could

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be a mismatch between the specific equities and bonds the foundation wishes toinvest in and the contracts available for *$ million. 6nless the '(day periode0actly matches the ' day period before e0piration dates on the contracts, theremay also be a timing mismatch.

*. The cost of the derivatives is 2potentially3 high. @or e0ample, if the mar"et ingeneral shares the committeeDs optimistic outloo", the premiums paid for callswould be e0pensive and the premiums received on puts would be lean. Theopportunity cost on all derivative strategies would be large if the committee iswrong on the outloo" for one or both mar"ets.

$. There may e0ist regulatory restrictions on the use of derivatives by endowmentfunds.

E3AL$ATION

The negative factors appear to outweigh the positive factors if the outloo" for the mar"etis neutral therefore, the committeeDs decision on using derivatives to bridge the gap for' days will have to be related to the strength of its conviction that stoc" and bond priceswill rise in that period. The certainty of receiving the gift in ' days is also a factor. Thecommittee should certainly beware that there is a cost to establish the derivativepositions, especially if its e0pectations do not wor" out. The committee might want toconsider a partial hedge of the *$ million.

11. 4 would advise them to e0ploit all available retirement ta0 shelters, li"e *'&b, *'1",Ceogh plans, 4As, etc. 7ince they will not be ta0ed on the income earned on these

accounts until they withdraw the funds, they should avoid investing in ta0(preferredinstruments li"e municipal bonds.

4f they are very ris"(averse, they should consider investing a large proportion of theirfunds in inflation(inde0ed 5Bs, which offer a ris"less real rate of return.

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1!. C.5. SNO CASE

a. 4ncome:2An item mar"ed A< is e0pected to increase at the rate of inflation. An item mar"ed;ominal is e0pected to remain fi0ed.3

4ncome from Trust Assets:re(ta0 After(ta0

/oney mar"et fund 29$,''' 1*.9%32;ominal3 11,'!$ 9,91#

/unis 21'$,''' #%3 2;ominal3 #,*'' #,*''

>ighway 5artage common 21!','''09.%32Aousehold 2Aer requirements cannot be met for this year without selling some assets. @urthermore,inflation will cause her e0penses, which are !1,1'' A< plus 9, ;=/4;A


21/35


22/35

liabilities. @uture returns are not generated by actuaries or by chairmen however, but bymar"ets, by asset(class e0posures within mar"ets, and by long(term relationships betweeneconomic and mar"et factors, all ta"ing place in the conte0t of funding, allocation, and payoutdecisions unique to @4Ds pension plan.

=f primary importance is that the return e0pected must be consistent with what thevarious alternative investment instruments available to the plan can reasonably be shown tooffer in terms of long(run productivity, with ris" considered. 4n general, @4Ds e0istingportfolio is not allocated in a manner that ma"es the most of li"ely long(runeconomicJmar"et conditions: 213 The portfolio holds only domestic securities. 2!3 Assetallocation, at $' percent stoc"s and $' percent bonds, appears to have been more acomfortable accident than a thought(out strategy. 2&3 4t holds only large(capitalizationequities. 2*3 4t holds only high(quality, long(maturity corporate bonds.

The possibility e0ists, then, that the portfolio could be improved in terms of e0pectedreturns without necessarily raising the ris" level. 4mproving it enough to meet thechairmanDs 1' percent level, however, may not be possible, which is the first thing to be

determined.

The data in Table !8> ma"e it apparent that, although 6.7. stoc" and bond returnshave been above the planDs long(term return assumption of percent during the past decade,they have also been well above their long(term historical norms. The forecast data indicate aconsensus that future returns will be more in line with the long(term record than with thee0ceptional levels recorded from 1#* to 1&. Accordingly, the chairmanDs observationshould not be turned into a recommendation to increase the rate of return assumption onthe contrary, given the tendency of rates to regress to the mean over long periods of time, amore appropriate recommendation would be to lower the assumed rate of return toward the# percent level and allocate the planDs assets accordingly.

The @4 plan might have been better funded than it is if the asset allocation decisionhad been given more attention or had been more e0pansive in asset(class terms in the past.The allocation shown below is an e0ample of a more appropriate mi0, in light of what we"now about the companyDs needs and goals. ven with the consensus forecast numberslowered considerably from recent e0perience, this allocation provides enhanced opportunityto improve returns without, relative to the present mi0, significantly increasing the level oftotal portfolio ris". 4mproved diversification through a broader range of asset classesrepresents a more realistic and opportunistic approach to the planDs mar"et e0posures andappears to offer a better prospect of meeting the planDs obligations over time than does thecurrent allocation.

To effect a change to a more rational and better diversified asset mi0 from thee0isting $' percent large(capitalization 6.7. stoc"sJ$' percent long(duration 6.7. corporatebond mi0, a number of additional asset types are available: intermediate(maturity Treasurybonds, non(6.7. bonds2AAA3, small(capitalization 6.7. stoc"s, non(6.7. stoc"s, and 6.7.real estate. =f these, several offer 2based on consensus e0pected returns3 levels of return

!8(!!


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that are comparable to or higher than current levels, at levels of ris" that, whendiversification benefits are considered, are the same as or only slightly higher than that of thee0isting mi0. @or e0ample, the following allocation moves the portfolio to 9'% equityJ&'%fi0ed(income assets with similar ris" as the current portfolio.

1*(!''' Eeightedercent of 0pected 0pected

Asset 5lass Total eturn eturnUUUFixed income 4ntermediate Treasury 1'% $.'% '.$'% 6.7. corporate AAA 1' 8.$ '.8$ ;on(6.7. AAA 1' 8.$ '.8$ 7ubtotal &'% 1.#'%Equity 6.7. large cap *'% #.$% &.*'% 6.7. small cap 1' 1'.$ 1.'$

;on(6.7. stoc"s 1' .$ '.$ 6.7. real estate 1' 9.$ '.9$

7ubtotal 9'% 8.1$% Total 1''% 9.$%

The chairmanDs desire to raise the long(term return assumption cannot be supported bypresent return levels or levels that can reasonably be e0pected. Ehat he sees in therearview mirror does not carry through to the road ahead. @rom a practical standpoint, infact, the return assumption should be lowered toward # percent, not raised from percentto 1' percent. To recommend an increase in the return assumption at this time would beboth imprudent and unreasonable.

b. A 6.7. pension planDs discount rate is the rate applied in determining the present value ofits pension obligations. Iecause the time period involved is obviously long(term, thediscount rate should bear some rational relationship to the long(term rates of interestpresent in the mar"et at the time of the calculation. The usual model for the discount rateis the rate at which high(quality, long(term bonds 2often the long Treasury, but the rate onlong corporates is also used3 are quoted, reflecting consensus e0pectations of long(runinflation plus a real rate of return. Iased on the consensus forecast in Table !8> andpresent capital mar"et conditions, a discount rate of 8(9 percent would be reasonable.@4Ds current using # percent discount rate is already out of line with such conditions. @4should, therefore, seriously consider adopting a lower rate. Thus, the capital mar"etconditions would be those that render the e0isting rate unrealistic as reflected in prevailinglong(term rates.

c. 4n the 6nited 7tates, every 47A(qualified defined(benefit pension plan has a FrojectedIenefit =bligation 2I=3,G which represents the discounted present value of theretirement benefits that the plan is obligated by law to ma"e, given certain assumptions

!8(!&


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about future rates of pay and wor"(force factors. 4f the Fplan assets at fair mar"et valueGe0ceed the I=, the plan is said to be Foverfunded.G 5onversely , if the plan assets areless than the I=, the plan is said to be 2as in this case3 Funderfunded.G ?iven that @4Dsplan is underfunded by !'' million, whereas its assets total 9$' million, its I= must be$' million. Amortization of this shortfall will add to @4Ds financial burdens. 4n moregeneral terms, an underfunded situation e0ists whenever the fair value of the assetsFsecuringG a liability is insufficient to e0tinguish the liability.

d. educing the discount rate applied to @4Ds pension benefit obligations would have theeffect of raising @4Ds discounted present value. Iecause the mar"et value of the assetsavailable to liquidate this obligation is unchanged, the underfunded situation would bemade worse by a discount(rate reduction. The size of the gap between the I= and thevalue of the assets, now !'' million, would be increased, as would the size of theamortization requirement.

18. a. 1. 6sing historical data O The use of long(term historical asset class data 2returns,standard deviations and correlation characteristics3 is the traditional method for

determining an optimal asset allocation focused on ma0imizing portfolio returnwhile minimizing portfolio ris". The usefulness of such long(term data will beenhanced by careful adjustment and updating to reflect important structuralchanges over the period that the data were being generated.

7trengths of this method include:

( 4ts appropriateness for setting long(term strategic targets.( 4ts simplicity and ability to accommodate as many asset classes for which valid

data are available.( The avoidance of forecaster bias.

Eea"nesses of this method include:

( 6nless adjusted, the raw historical data may not represent a valid model offuture return, variability or correlation e0perience and, hence, represent apoor base for optimization.

( Asset class characteristics often deviate from long(term trends over businesscycles and even longer periods of time. Accordingly, use of this method isinappropriate for short(and intermediate(term allocation applications.

( articularly when setting ris"Jreturn objectives for individuals, the concepts ofstandard deviation and correlation as ris" and diversification measures mayimpede understanding and acceptance.

!. /ultiple scenario forecasting O This method involves establishing a set ofeconomicJmar"et e0pectations based on different possible scenarios that have hadprobabilities assigned to their occurrence. The mi0 of scenarios may include those basedon past e0perience as well as those based on econometric modeling.

!8(!*


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7trengths of this method include:

( This method fosters recognition of the li"elihood of error in the Fmost li"elyGforecast because it forces assessment of the probabilities of occurrence for otherscenarios, including especially the Fworst caseG scenario.

( 4ts time independence allows short( or intermediate(term e0pectations or situations

to be included in the allocation process.( 4t forces the forecaster to focus on the "ey variables affecting the forecast and to

consider the forecast from a variety of points of reference.( 4t reduces a comple0 tas" to wor"able proportions and provides an e0cellent

mechanism for communicating common(based information across an organization.

Eea"nesses of the method include:

( The li"elihood of forecaster bias, in which FhopesG enter the process and the rangeof scenario content fails to capture the e0tremes of the distribution possibilities.

( The large number of e0plicit assumptions and relationships required to be specified.( The possibility that errors may come into play as, for e0ample, in establishing levels

of probability for each scenarioDs occurrence.

&. AssetJ


26/35

( A long time horizon is available no near(term cash needs e0ist and the wor" force is

of a relatively young age.( The planDs ris"(assuming capacity is above(average.( The plan has a total return objective, e0pressed in real terms, accompanied by a goal

of growing surplus over time.(


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"on-.S. Stoc!s. This allocation is warranted by the presence in the planliabilities of a growing non(6.7. dollar component and by the generalconsiderations cited above. 4n addition, the immediate diversification and long(term return enhancement aspects of such e0posure are other factors ofjustification. 4n the conte0t of the long term, hedging is not an appropriatestrategic move for T5 given the growing non(dollar liabilities. 4n the short run,tactical hedging may be considered from time to time as a source of added return.

Equity #eal Estate. ?iven the importance of inflation protection to the plan andthe past success of real estate in protecting value in periods of high inflation, ameaningful allocation to this asset class is justified. 4n addition, the diversificationbenefits of including real estate equities in this portfolio are a further plus, as arethe li"ely level and stability of the assetDs income stream.

.S. $onds. The justification for 6.7. bond holdings is their role as a deflationhedge, their diversification value and the stability of their interest earnings in asituation where liquidity will be "ept to a minimum. 4n an emergency, they also

represent a ready source of cash.

"on-.S. $onds. As is the case with non(6.7. stoc"s, this asset class e0posure isjustified by its diversification benefits, and its usefulness in relation to the non(6.7. liabilities. 4n addition, the deflation(hedge role of bonds is of some value, asis their steady income and their availability as a source of cash in an emergency.

Cash Equivalents. Although the plan contemplates minimal liquidity reserves,residual cash is always present and some deflation and income continuity benefitsare present. Iy identifying this asset class as a specific element in the allocationprocess, the optimization solution will more accurately identify appropriate

allocations to the other asset classes at alternative ris"Jreturn levels.

c. 2i3 The two primary asset class statistics required to develop optimal assetallocations, in addition to returns, are standard deviations and correlationsbetween asset classes. The roles they play are as follows:

7tandard deviations are the widely accepted measure of portfolio ris". Iecausehigher(returning assets have higher commensurate ris" over the long(run, utilizingthis ris" measure serves to limit e0posure to the highest(returning and thus ris"iestasset in the asset allocation process. 7uch a measure is required to determine anoptimal solution such that return is ma0imized over the long term withinacceptable levels of return variance over shorter time periods.

5orrelations are the measure of co(movement between assets or asset classes overtime. They are a critical input in the asset allocation process allowing for propermeasurement of ris" associated with portfolios comprised of investments providing

!8(!9


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different returns during the same time period. owever, realestate e0posures may be difficult to adjust in the short run due to liquidityconstraints it is assumed that this would be the case here, and its level has,therefore, not been adjusted.

Eithin the reduced equity e0posure, 6.7. stoc"s have been adjusted in the sameproportion as non(6.7. stoc"s 2(1'% from the *'% equals &'% vs. O$% from!'% equals 1$%3 despite better relative 6.7. return e0pectations 2e0cept in the

!8(!#


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rapid growthJhigh inflation case3 out of a desire to continue to provide via non(6.7. equity e0posure an offset to the companyDs non(6.7. pension benefitliabilities. Ta"en together, non(6.7. equity and bond e0posure is thus maintainedat the &'% level before and after this overall tactical shift.

7ummary of suggested adjustments:

referred7trategic TacticalAllocation Adjustment Allocation

6.7. 7toc"s *' (1'% P&'%

;on( 6.7. 7toc"s !' ($% 1$

quity eal state 1' ;.5. 1'6.7. Ionds 1$ K1'% P!$

;on(6.7. Ionds 1' K$ 1$

5ash quivalents $ ;.5. $1''% 1''%

PAn acceptable alternative allocation would be &$% 6.7. stoc"s and !'% 6.7. Ionds.

d. @utures and options may be used to increase and decrease asset class e0posures. @ore0ample, 213 e0posures could be increased by buying futures or selling put options on anequity inde0 or a particular type of bond or 2!3 e0posure could be decreased by sellingfutures or buying put options on an equity inde0 or bond. The choice of instrument and

the specific characteristics of that instrument are dependent on the underlying investmentsin the planDs asset class e0posure, and the level of ris" reduction the plan sponsor is tryingto achieve. Berivative securities cannot be used to alter e0posure to all asset classes 2e.g.,real estate3 due to lac" of availability.

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7trengths, or reasons for using derivatives, include:

( Their cost(effectiveness compared to trading underlying securities in that transactionscosts are low. 25ost effectiveness is also dependent, though, on the relative pricing of thederivative.3

( The ability to act immediately with no mar"et impact on the underlying position. 2There

is, however, a possible impact within the derivatives mar"et.3

Eea"nesses, or reasons against using derivatives, include

( ollover problems, in that the e0piration of the derivatives position will not li"ely matchthe investorDs timetable regarding e0posure changes. Therefore, the investor is e0posed toadditional price(change ris".

( The lac" of availability of derivatives in some asset classes, notably real estate.( 0posures to pricing inefficiencies between the derivatives and the underlying mar"ets.( 4nefficiencies in derivatives mar"ets in some foreign equity mar"ets which increases ris"

related to price volatility or e0posure mismatch.( 5urrency ris" associated with foreign derivatives used to hedge underlying foreign

positions with currency e0posure.

19. a. >istorically the primary investment benefits of owning unlevered real estate have been ris"reduction and attractive real return. Ioth contentions are based on real estateDs historicalaverage return along with its low correlation with other asset classes.

Attractive real returns are based in part on the ability of real estate owners to adjustincome streams by recovering increased costs at the time of lease roll(over andJor throughvarious types of escalator clauses designed to maintain mar"et rents. roperty value maybe maintained or increased by increased income originating from escalator clauses or therenewal of leases in strong leasing environments. The ability of real estate assets to adjust

income streams during periods of high inflation and provide capital gains argues forincluding real estate as both a source of diversification and a hedge against inflation.

7everal sources report a low standard deviation of returns for real estate as an asset classcompared to common stoc". /ore importantly, the reported small covariability ornegative correlation of real estate returns with other asset classes ma"es real estateattractive due to the portfolio ris" reduction possibilities attributable to this diversificationeffect.

The ability of real estate to provide attractive real returns and a hedge against inflationmay be negatively influenced by local conditions. oor management and location specificfactors such as overbuilding andJor the deterioration of the local economy can impair theleasing environment by lowering the income stream and result in lower property values.6nder such conditions the reported inflation hedging characteristics of real estate aredifficult to achieve.

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/easurement of real estate returns is complicated by the limited availability oftransactions(based data and the need to rely on appraised values to calculate periodicreturns, the standard deviations about these returns, and the covariance of these returnswith other asset classes. This appraisal induced smoothing may understate both the actualstandard deviations of returns and the covariance with other asset classes. 4f these datadeficiencies are strong and occur simultaneously, then real estate returns may, at least inthe short run, be materially misrepresented.

b. =ver the course of the ne0t five years, the property will not support either of the twoclaims. The loss of the principal tenant in a depressed rental mar"et will result in any newleases that can be negotiated being written at the mar"et rate, well below the rates fore0isting leases.


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$. As the participants own the assets in the form of individual rights to proportionateshares of the total value on the date of withdrawal via termination or retirement,they 2not the company3 bear the full ris" of fluctuation andJor loss and do soindividually and

8. Ehile, in principle, the participants should individually direct investment action inaccordance with their own individual investment objectives, constraints, andpreferences, this ideal situation does not e0ist in the situation described.

?iven these facts, the corollary inferences that may be drawn from them, and otherinformation provided in the preamble, an appropriate investment policy statement for theplan would:

( mphasize positive real total return production and preservation of capital valuesas primary investment objectives. 7ince investment income is the only source ofnew money for the portfolio, and as it compounds until individual withdrawals

occur, production of a significant level of current income is desirable but not anend in itself. Eith some participants having many years of further involvement,growth of principal in addition to income is an important consideration as well.

( eflect the fact that the planDs investment horizon is not infinite many participantsare already FolderG and some will be retiring sooner rather than later, ma"inglump(sum withdrawal demands on the portfolio which its liquidity planning mustta"e into account. @requent cash flow analyses from the actuary are needed aspart of that planning process.

( rovide ongoing attention to both 47A and 4nternal evenue 7ervice rules and

requirements, as this is a qualified, ta0(free situation whose integrity must bepreserved for the participants.

( eflect the situationDs unique aspects, namely the absence of e0ternal cash flows2the fund is FfrozenG3, a participant group which is not representative of the wor"force as a whole and a liability set which is not reflective of the internationalinvolvements or requirements e0isting in the defined benefit 2pension3 plan 2fore0ample, there is no requirement for any non( 6.7. return component3.

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b. An effective way to compare the elements of the two plansD policy statements is to placethese elements in a common framewor" as follows:

ension lan rofit(sharing lanObjectives:

eturn 7ee" high 7ee" moderate realinflation(adjusted total returns with somereturn. /aintainJincrease growth of both incomeplan surplus. and principal.

is" Above(average Ielow(averagecapacity aggressive capacity no Fdeepposture acceptable. poc"etG or further

contributions.

Constraints:

Time >orizon Qery long wor" /edium, possibly veryforce average is short as to individualyoung. participants but still

long for others.


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The major differences between appropriate policies for the two plans are:

1. The difference in ris" objective, where the profit sharing plan is best served by anabove(average level. 4n the pension case, T5 provides a Fdeep poc"etG and acontinuing flow of contributions that will cushion temporary declines in mar"etvalues. The profit sharing plan has no inflow from contributions and all losses,temporary or permanent, in investment values are borne by the participantsthemselves.

Ioth plans will benefit from a real, total return objective, but the profit sharingplanDs policy will also see capital preservation as part of a realistic return goal.

!. The difference in time horizon, which reflects not only the difference in the age mi0of the participants but also the fact that the profit sharing plan has a finiteliquidation ahead while the pension plan will go on virtually indefinitely.

&. The difference in provision which must be made for liquidity, which is significant in

the profit sharing case but irrelevant for the pension plan.

*. The fact that the pension plan must accommodate a sizeable and growing amountof non(6.7. dollar liabilities while the profit sharing plan is free of suchconsiderations is also an important policy(influencing difference between the two.>owever, the absence of specific non(dollar liabilities in the profit sharing caseshould not preclude investment of a portion of participantsD interests ininternational securities for the diversification and potential for return enhancementthat so doing would provide.

$. There are unique circumstances in both situations that must be accommodated in

the investment policies, as noted above. >owever, ta0 and regulatory aspects aresimilar in each case.

c. The grounds cited by the opposing committee member are wea", inappropriate, andinvalid in the conte0t of the plan as it e0ists. The memberDs objection ignores the fact thatthe sole interests to be served here are those of the participants and that the sole questionto be answered therefore is whether or not the addition of the international vehicle wouldimprove their investment alternatives. erhaps this committee member has equated therequirements of the pension plan 2where it is necessary to have a non(6.7. securitiescomponent specifically structured to reflect the planDs non(6.7. liabilities3 with the absenceof such requirements in the profit(sharing plan.

The issue for the profit(sharing plan is not requirements 2there are none3 but ratherpotential benefits to be gained by the use of a non(6.7. securities component. ;either the6.7. base of the participant set nor the solely 6.7. nature of the liabilities is a valid reasonfor opposition the decision for or against the chairmanDs proposal should be made on thebasis of relevant investment characteristics.

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Those relevant investment considerations would include:

1. Biversification Ienefit

vidence is strong that the addition of securities 2mar"ets3 not highly correlatedwith an investorDs domestic securities 2mar"ets3 reduces the ris" of a portfolio, inthe same way and for the same reasons that diversifying a portfolio of domesticsecurities 2mar"ets3 reduces ris". That is, international diversification helpsimprove the ris"(adjusted performance of a domestic(only securities portfolio dueto the relatively low correlation between the non(6.7. and 6.7. asset classes.

!. 4ncremental erformance otential

Addition of an international securities component would provide the portfolio withaccess to an enhanced mi0 of return opportunities, adding e0posure to many setsof economic and mar"et conditions where only one set e0isted before. These

additional e0posures would not only improve diversification but would alsoprovide potential for incremental return performance over time.

&. 47A

47A guidelines on prudent investment for the sole benefit of plan participantsmandate diversification international e0posure in appropriate form andproportions would help meet this mandate.

&. 5urrency is"

Ehile the introduction of a non(6.7. securities component does introducecurrency ris", such ris" can be actively managed through a hedging program,leaving all or most of the diversification benefit intact.

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