portfolio management - chapter 4

8/3/2019 Portfolio Management - Chapter 4

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Chapter 4

Setting Portfolio Objectives

Prof. Rushen Chahal 1

Prof. Rushen Chahal


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Todays put-off objectives reduce tomorrows

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 financial

planning

Too many investors have a casual attitude

It is easy to be imprecise in communicating with

the portfolio manager

Gallup survey finds 39% believe stocks will return15% annually for next ten year



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Introduction (contd)

Pension and Investments article states

importance of setting portfolio objectives:

Two factors contribute to a sponsors successfulinvestment program:

Suitable investment objectives and policy

Successful selection of the investment managers toimplement 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, andriskmean different things to differentpeople

E.g., a savings account provides income only; ithas no growth potential

There must be a clear understanding of the

terms when entrusting money to a fundmanager



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Semantics (contd)

Interpretation ofPrincipaland 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 clients inability to make a decision

E.g., a bank customer wants to have interestcompounded but have the interest send

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 onebeneficiary

E.g., an endowment fund has a perpetual life

It is possible to increase current income from theportfolio

Benefits todays beneficiaries

May be at the expense of futures beneficiaries E.g.,Social Security and federal unemployment

insurance



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Investment Policy Versus

I

nvestment Strategy Investment policydeals with decisions that

have been made about long-term

investment activities, eligible investment

categories, and the allocation of funds

among the categories

E.g., a pension fund decides never to place more

than 30% in common stock



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Investment Policy Versus

I

nvestment Strategy (contd) Investment strategydeals 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 managers may be required to maintain at least

30% equity by policy but decides to put 50% 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

Tax-free income generation

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 bythe funds owner or overseer?



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Traditional Portfolio Objectives

Stability of principal

Income

Growth of income

Capital appreciation



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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 (contd)

Appropriate investment vehicles:

Bank certificates of deposit

Other money market instruments



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Assessing

T

ax-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 of he holds the note to

maturity



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Income (contd)

Appropriate investment vehicles:

Corporate bonds

Government bonds

Government agency securities

Preferred stock

Common stock



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Growth ofIncome

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 ofIncome (contd)

Often seek to have the annual income

increase by at least the rate of inflation

Requires some investment in equity

securities



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Example

Two portfolios have an initial value of $50,000. Interest rates

are expected to remain at a constant 10% per year for the nextten years.

Portfolio A has an income objective and seeks to providemaximum income each year. The portfolio is invested 100% indebt securities. Thus, Portfolio A generates $5,000 in incomeeach year.



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Example (contd)

Portfolio B seeks growth of income and contains both debt and

equity securities. Portfolio B has an annual total return of 13%.In the first year, Portfolio B provides $3,500 in income (a 7%income yield) and experiences capital appreciation of 5%.

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



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Example (contd)


$5,000

$6,180

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

1999 2001 2003 2005 2007 2009

Portfolio A

Portfolio B


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Capital Appreciation

The goal is for the portfolio to grow in value

and not to generate income

Appropriate for investors who have no

income needs



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Capital Appreciation (contd)

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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Example

Consider two $10,000 investments. Both investments have a

10% 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%.



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Example (contd)

Consider an investor in the 28% 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 IRRcalculations are shown

on the next slides.



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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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Example (contd)

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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Example (contd)

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:


426.6820

(1 )

7.47%

R

R

!

!


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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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Example (contd)

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 23.61

20 (1 ) (1 ) (1 ) (1 )

8.04%

R R R R

R

!

!


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Example (contd)

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 41.01 1.04 1.07 22.9120 (1 ) (1 ) (1 ) (1 )

7.29%

R R R R

R

!

!


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Tax-Free Income Generation

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 incomestrategy

Invest in a mix of municipal bonds and common

stock for a growth-of-income strategy



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Tax-Free Income Generation

(contd)

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 causediscomfort

Utility comes from quantifiable andnonquantifiable 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 &

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


Primary Objective

Secondary

Objective

Stability of

Principal Income

Growth of

Income

Capital

Appreciation

Stability ofPrincipal

X Debt andPreferred

Stock

UnacceptableGoals

?

Income Short-term

debt

X At least 40%

equity

?

Growth ofIncome

Unacceptablegoals

Varies: often> 40% equity

X At least 75%equity

Capital

Appreciation

Unacceptable

goals

? At least 75%

equity

X


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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 tomaturity



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Portfolio Splitting

A fund manager receives instructions thatrequire that the portfolio be managed inmore 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, overallobjective



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Liquidity

Liquidityis 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 withcheck-writing privileges



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The Role of Cash

Investment management firms routinelyprescribe portfolio proportions for:

Equity securities

Fixed-income securities

Cash

Arrives in portfolios naturally though the receipt ofdividends and interest



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The Role of Cash (contd)

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 thatit services the requirements of a

corresponding liability or portfolio ofliabilities

Overlays the primary and secondary investmentobjectives

The two principal methods are cash matchingand 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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DurationMatching

Involves constructing a portfolio of assets

that pays the billsassociated 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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DurationMatching (contd)

In a duration-matched portfolio:

A rise in interest rates results in a decline in theportfolios value that is approximately offset by

additional income earned from the higherreinvestment rate

A fall in interest rates results in a decline inincome from reinvested funds that is

approximately offset by the increase in themarket value of the portfolio



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DurationMatching (contd)

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

Prof Rushen Chahal 55

portfolio management - chapter 4

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