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Chapter 3

Setting Portfolio Objectives

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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Today’s put-off objectives reduce tomorrow’s achievements.

Harry F. Banks

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Outline Introduction Why Setting Objectives Can Be Difficult Portfolio Objectives The Importance of Primary and Secondary

Objectives Other Factors to Consider in Establishing

Objectives Portfolio Dedication

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Introduction Setting objectives is important for every

person and institution that uses the financial market• Too many investors have a casual attitude• It is easy to be imprecise in communicating

with the portfolio manager• Gallup survey finds 39 percent believe stocks

will return 15 percent annually for next ten years

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Introduction (cont’d) A Pension and Investments article states the

importance of setting portfolio objectives:• Two factors contribute to a sponsor’s

successful investment program:– Suitable investment objectives and policy

– Successful selection of the investment managers to implement policy

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Why Setting Objectives Can Be Difficult

Semantics Indecision Subjectivity Multiple Beneficiaries Investment Policy versus Investment

Strategy

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Semantics Growth, income, return on investment,

and risk mean different things to different people

• e.g., a savings account provides income only; it has no growth potential

• There must be a clear understanding of the terms when entrusting money to a fund manager

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Semantics (cont’d) Interpretation of principal and income

• One interpretation is that principal is the original amount (accumulated interest is not included)

• Another interpretation is that accumulated interest is included in principal following the initial year

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Indecision The client’s inability to make a decision

e.g., a bank customer wants to have interest compounded but have the interest sent home each month

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Subjectivity Investing is both an art and a science

• There are inevitably shades of gray that involve subjective judgments

• e.g., which stocks are considered “growth” and which are considered “income?”

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Multiple Beneficiaries Investment portfolios often have more than one

beneficiary• e.g., an endowment fund has a perpetual life

It is possible to increase current income from the portfolio

• Benefits today’s beneficiaries• May be at the expense of future beneficiaries• e.g., Social Security and federal unemployment

insurance

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Investment Policy versus Investment Strategy

Investment policy deals with decisions that have been made about long-term investment activities, eligible investment categories, and the allocation of funds among the eligible investment categories

• e.g., a pension fund decides never to place more than 30 percent in common stock

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Investment Policy versus Investment Strategy (cont’d)

Investment strategy deals with short-term activities that are consistent with established policy and that will contribute positively toward obtaining the objective of the portfolio

• e.g., a manager may be required to maintain at least 30 percent equity by policy but decides to put 50 percent in the stock market because of a belief that the market will advance in the near future

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Portfolio Objectives Preconditions Traditional Portfolio Objectives Special Situation of Tax-Free income Portfolio Objectives and Expected Utility

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Preconditions Questions to be answered before setting

objectives and formulating strategy:• Assess the existing situation

– What are the current needs of the beneficiary?

– What is the investment horizon?

– Are there special liquidity needs?

– Are there ethical investing concerns established by the fund’s owner or overseer?

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Traditional Portfolio Objectives

Stability of Principal Income Growth of Income Capital Appreciation

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Traditional Portfolio Objectives20

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16

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12

10

8

6

4

2

0

exp

ecte

d r

etu

rn

standard deviation (%)

capital appreciation

growth of income

0 6 12 18 24 30 36

income

inflationT-bills

intermediate-term

governmentbonds

long-termgovernment bonds

long-termcorporate bonds

large company stocks

smallcompany

stocks

stabilityof principal

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Stability of Principal Emphasis is on preserving the “original”

value of the fund• The most conservative portfolio objective

• Will generate the most modest return over the long run

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Stability of Principal (cont’d) Appropriate investment vehicles:

• Bank certificates of deposit

• Other money market instruments

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Assessing Tax-Exempt Bonds

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Income No specific proscription against periodic

declines in principal value• e.g., a Treasury note may experience a decline

in value if interest rates rise, but the investor will not experience a loss if he holds the note to maturity

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Income (cont’d) Appropriate investment vehicles:

• Corporate bonds• Government bonds• Government agency securities• Preferred stock• Common stock

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Growth of Income Benefits from time value of money

• Sacrifices some current return for some purchasing power protection

Differs from income objective• Income lower in earlier years• Income higher in later years

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Growth of Income (cont’d) This objective often seeks to have the

annual income increase by at least the rate of inflation

Requires some investment in equity securities

• Or, possibly, inflation-protected securities such as TIPS

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Growth of Income (cont’d)Example

Two portfolios have an initial value of $50,000. Interest rates are expected to remain at a constant 10 percent per year for the next ten years.

Portfolio A has an income objective and seeks to provide maximum income each year. The portfolio is invested 100 percent in debt securities. Thus, Portfolio A generates $5,000 in income each year.

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Growth of Income (cont’d)Example (cont’d)

Portfolio B seeks growth of income and contains both debt and equity securities. Portfolio B has an annual total return of 12 percent. In the first year, Portfolio B provides $3,500 in income (a 7 percent income yield) and experiences capital appreciation of 5 percent.

The income generated by both portfolios over the next ten years is shown graphically on the following slide.

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Growth of Income (cont’d)Example (cont’d)

$5,000

$6,180

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

2005 2007 2009 2011 2013 2015

Portfolio APortfolio B

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Capital Appreciation The goal is for the portfolio to grow in

value rather than generate income

Appropriate for investors who have no income needs

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Capital Appreciation (cont’d) A major benefit is tax savings

• Unrealized capital gains are not taxed• Dividend and interest income is taxed

The investor can defer taxes for many years by successful long-term growth stock investing

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Capital Appreciation (cont’d)Example

Consider two $10,000 investments. Both investments have a 10 percent expected rate of return annually on a pretax basis. Investment A involves the purchase of 500 shares of a $20 common stock that does not pay dividends. Investment B involves the purchase of 500 shares of a $20 common stock that has a constant dividend yield of 7 percent.

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Capital Appreciation (cont’d)Example (cont’d)

Consider an investor in the 28 percent tax bracket. The investor will hold both investments for four years.

The projected cash flows over the next four years for both investments and the corresponding IRR calculations are shown on the next slides.

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Capital Appreciation (cont’d)Investment A (no dividends)

10% Pretax Annual Return

Year

(0) (1) (2) (3) (4)

Price $20.00 $22.00 $24.20 $26.62 $29.28

Dividends — 0 0 0 0

– Tax (28%) — 0 0 0 0

Cash flow $0 $0 $0 $0 $29.28

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Capital Appreciation (cont’d)

Example (cont’d)

If the investor does not sell Investment A after four years, his after-tax internal rate of return is:

4

29.2820

(1 )

10.00%

R

R

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Capital Appreciation (cont’d)

Example (cont’d)

If the investor sells Investment A after four years, his year 4 cash flow is reduced by capital gains taxes of $2.60 and his after-tax internal rate of return is:

4

26.6820

(1 )

7.47%

R

R

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Capital Appreciation (cont’d)Investment B (7% dividend yield)

10% Pretax Annual Return

Year

(0) (1) (2) (3) (4)

Price $20.00 $20.60 $21.22 $21.85 $22.51

Dividends — 1.40 1.44 1.49 1.53

– Tax (28%) — 0.39 0.40 0.42 0.43

Cash Flow $0 $1.01 $1.04 $1.07 $23.61

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Capital Appreciation (cont’d)

Example (cont’d)

If the investor does not sell Investment B after four years, his after-tax internal rate of return is:

2 3 4

1.01 1.04 1.07 23.6120

(1 ) (1 ) (1 ) (1 )

8.04%

R R R R

R

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Capital Appreciation (cont’d)

Example (cont’d)

If the investor sells Investment B after four years, his year 4 cash flows is reduced by capital gains taxes of $0.70, and his after-tax internal rate of return is:

2 3 4

1.01 1.04 1.07 22.9120

(1 ) (1 ) (1 ) (1 )

7.29%

R R R R

R

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Special Situation of Tax-Free Income

Accomplished by investing in municipal securities

• Free from federal tax and may be free from state and local taxes

Invest directly in municipal bonds for an income strategy

Invest in a mix of municipal bonds and common stock for a growth-of-income strategy

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Special Situation of Tax-Free Income (cont’d)

Invest in a municipal bond mutual fund for a stability of principal strategy

Tax-free income generation is unrealistic for a capital appreciation strategy

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Portfolio Objectives and Expected Utility

Utility is one of the most useful of all economic concepts

• We seek out satisfying things and avoid things that cause discomfort

Utility comes from quantifiable and nonquantifiable sources

• e.g., an investor may choose his own stocks rather than investing in mutual funds for the “thrill of the hunt”

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The Importance of Primary and Secondary Objectives

Introduction Possible Combinations of Objectives

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Introduction The secondary objective indicates what

is next in importance after specification of the primary objective

• e.g., an investor chose income as the primary objective, but:

– Does not want to take a lot of risk with the invested money (stability of principal)

– Wants to keep up with inflation (growth of income)

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Possible Combinations of Objectives

XAt least 75% equity

?Unacceptable goals

Capital Appreciation

At least 75% equity

XVaries: often > 40% equity

Unacceptable goals

Growth of Income

?At least 40% equity

XShort-term debt

Income

?Unacceptable Goals

Debt and Preferred

Stock

XStability of Principal

Capital Appreciation

Growth of Income

Income

Stability of Principal

Secondary Objective

Primary Objective

? = unusual combinations involving a need to tailor a portfolio to a very specific need.X = not applicable.

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Other Factors to Consider in Establishing Objectives

Inconsistent Objectives Infrequent Objectives Portfolio Splitting Liquidity The Role of Cash

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Inconsistent Objectives Certain primary/secondary combinations

are incompatible• Primary: stability of principal

• Secondary: capital appreciation– “I want no chance of a loss, but I do want capital

gains”

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Infrequent Objectives

Certain primary/secondary combinations are infrequent

• Primary: capital appreciation

• Secondary: stability of principal– Could invest in low coupon bonds selling at a

substantial discount from par and hold the bond to maturity

– The use of TIPS could also be a possibility

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Portfolio Splitting A fund manager receives instructions that

require that the portfolio be managed in more than one part

• e.g., endowment funds Components will have different objectives A more convenient way of administering

the fund than trying to establish a single, overall objective

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Liquidity Liquidity is a measure of the ease with

which something can be converted to cash

Clients may desire some liquidity• Options: invest a portion of the portfolio in

money market mutual funds or cash management accounts at brokerage firms with check-writing privileges

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The Role of Cash Investment management firms routinely

prescribe portfolio proportions for:• Equity securities

• Fixed-income securities

• Cash– Arrives in portfolios naturally though the receipt

of dividends and interest

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The Role of Cash (cont’d) Cash contributes to portfolio stability,

especially during periods of rising interest rates

Cash includes:• Currency• Money market instruments

– e.g., Treasury bills

• Short-term interest-bearing deposit accounts

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Portfolio Dedication Introduction Cash Matching Duration Matching

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Introduction Portfolio dedication (liability funding)

involves managing an asset portfolio so that it services the requirements of a corresponding liability or portfolio of liabilities

• Overlays the primary and secondary investment objectives

• The two principal methods are cash matching and duration matching

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Cash Matching The most common form of portfolio

dedication

A manager assembles a portfolio of bonds whose cash flows match as nearly as possible the requirements of a particular liability

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Duration Matching Involves constructing a portfolio of assets

that “pays the bills” associated with a liability or stream of liabilities

Duration is a measure of interest rate risk• The higher the duration, the greater the

fluctuation in the price of a bond due to interest rate changes

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Duration Matching (cont’d) In a duration-matched portfolio:

• A rise in interest rates results in a decline in the portfolio’s value that is approximately offset by additional income earned from the higher reinvestment rate

• A fall in interest rates results in a decline in income from reinvested funds that is approximately offset by the increase in the market value of the portfolio

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Duration Matching (cont’d) There are two keys to duration matching

• The duration of the asset portfolio must match the duration of the liabilities

• The present value of the liabilities to be paid must equal the market value of the asset portfolio