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PART EIGHT: INVESTMENT MANAGEMENT Chapter 21: CHAPTER OVERVIE Chapter 21 covers some portfolio management topics primarily

having to do with actual investment practice. The emphasis in Chapter 21 is on the more practical, day-to-day aspects of portfolio management whereas Chapters 19 and 20 cover the theoretical aspects of portfolio management. Chapter 21 is designed to integrate very closely with A !"#s approach to portfolio management, which emphasi$es that it is a process to %e followed %y all firms and managers. &hile the details will vary from manager to manager, the process will %e the same. Chapter 21 %egins %y e'plaining portfolio management as a process, integrating a set of activities in a logical and orderly manner. The process is systematic, continuous, dynamic, and fle'i%le. t encompasses all portfolio investments. (aving structured portfolio management as a process, any portfolio manager can e'ecute the necessary decisions for an investor. )igure 21-1 outlines the process as descri%ed %y !aginn and Tuttle in Managing Investment Portfolios, an A !" %oo* on the su%+ect. These steps are descri%ed in more detail in the chapter. ndividual investors are contrasted with institutional investors. nstructors may wish to add their own detail in this area. Covered here are such concepts as the life cycle. The remainder of the chapter focuses on the steps in the investment process. The first step, the determination of portfolio policies, receives the most emphasis %ecause this is the part of the process involving o%+ectives, constraints, and preferences, and this material receives the %ul* of the attention in the C)A program. Portfolio Management


The other steps in the process are discussed, and details are added where appropriate. )or e'ample, in the discussion of forming e'pectations, the author,s wor* on pro%a%ilities associated with common stoc* returns is included. This material allows students to see the ris* involved with common stoc*s, and can %e a good focal point for class discussion. -ther important topics are discussed in this chapter. These include the important topic of asset allocation, including the types of asset allocation. -ther topics are also touched upon, such as portfolio optimi$ation and the costs of trading. CHAPTER O!"ECTIVES

To discuss why portfolio management should %e thought of, and implemented as, a process. To descri%e the steps involved in the portfolio management process. To assess related issues of importance, such as asset allocation.


MA"OR CHAPTER HEA#INGS $Content%& Portfolio Management a% a Pro'e%% .description of the process and what is involved/ outline of the steps/ figure showing the process0

ndividual nvestors vs. nstitutional nvestors .a summary of the differences %etween the two/ characteristics of investment policies for each0

(orm)late an Appropriate In*e%tment Poli'+ .overall view0

-%+ectives .discussion of life cycle for individual investors/ inflation considerations0 Constraints and 1references .time/ li2uidity/ ta'es/ regulatory/ uni2ue needs/ e'ample of stating all of these factors for two different investors0

#e*elop In*e%tment Strategie% .)orming 3'pectations--macro and micro/ rate of return assumptions--importance of historical data/ arithmetic and geometric means/ pro%a%ilities associated with common stoc* returns0 Constructing the 1ortfolio .steps in the process0 Asset Allocation .importance/ ma*ing the decision/ e'ample/ types of asset allocation0 1ortfolio -ptimi$ation .the !ar*owit$ model0

Monitor Mar,et Con-ition% an- In*e%tor Cir')m%tan'e% 47

!onitoring !ar*et Conditions Changes in nvestor Circumstances

Ma,e Portfolio A-.)%tment% A% Ne'e%%ar+ .the costs of trading0 1erformance !easurement .introduction to Chapter 22, which covers the evaluation of portfolio performance0 POINTS TO NOTE A!O/T CHAPTER 21 Ta0le% an- (ig)re% )igure 21-1 is a diagram, from !aginn and Tuttle, of the portfolio management process. )igure 21-2 illustrates ris*4return positions at various life cycle stages. Ta%le 21-1 contains the pro%a%ilities associated with common stoc* returns as calculated and reported in The Journal of Portfolio Management. This is a very detailed ta%le of pro%a%ilities and can %e used to show the ris* of common stoc*s. Ta%le 21-2, ta*en from AAII Journal, illustrates some asset allocation possi%ilities depending upon stage in the life cycle and ris* posture assumed. !o1 In%ert% There are no %o' inserts for Chapter 21.


ANS ERS TO EN#2O(2CHAPTER 3/ESTIONS 21214 1ortfolio management is %est thought of as a process, meaning that it can applied in any situation to any manager. As a process, it is continuous, systematic, dynamic and fle'i%le, and it applies to all investments. 5-6 The process should %e used %y all managers, %ut the details can vary. Therefore, firms can %e organi$ed differently. A ma+or difference %etween the two occurs with regard to time hori$on %ecause institutional investors are often thought of on a perpetual %asis, %ut this concept has no meaning when applied to individual investors. As e'plained %elow, for individual investors it is often useful to thin* of a life cycle approach, as people go from the %eginning of their careers to retirement. This approach is less useful for institutional investors %ecause they typically maintain a relatively constant profile across time. 7aiser has summari$ed the differences %etween individual investors and institutional investors as follows81 1. ndividuals define ris* as 9losing money: while institutionals use a 2uantitative approach, typically defining ris* in terms of standard deviation ;as in the case of the %%otson data presented in Chapter <=. ndividuals can %e characteri$ed %y their personalities, while for institutions we consider the investment characteristics of those with a %eneficial interest in the portfolios managed %y the institutions.




1 See Ronald W. Kaiser, Individual Investors, in Managing Investment Portfolios, 2nd. ed., John L. Maginn, CF and !onald L. "uttle, CF , eds. #Charlottesville, $a.% sso&iation 'or Invest(ent Manage(ent and Resear&h, 1))*+, ,. -.2.


?oals are a *ey part of what individual investing is all a%out, along with their assets, while for institutions we can %e more precise as to their total pac*age of assets and lia%ilities.


ndividuals have great freedom in what they can do with regard to investing, while institutions are su%+ect to numerous legal and regulatory constraints. Ta'es often are a very important consideration for individual investors, whereas many institutions, such as pension funds, are free of such considerations.



The investment policy is the first step in the portfolio management process. t consists of o%+ectives, constraints, and preferences, and sets the stage for the entire process. The investment policy descri%es what the investor is trying to achieve in terms of return and ris*, and the investor,s constraints and preferences. The investment policy statement spells out the investor,s o%+ectives, constraints and preferences, there%y ma*ing operational a statement for investment managers to follow. )or e'ample, if, under constraints, it is stated that the investor is in the highest ta' %rac*et and wishes to hold some %onds, the manager may %e guided very 2uic*ly to municipals. The asset allocation decision, having %een made, has the greatest impact on the portfolio. )or e'ample, if it is decided to allocate 90 percent of the portfolio to stoc*s, a strong upward stoc* mar*et, or a strong downward mar*et, will clearly have a very large impact on the performance of the portfolio. 1. Btrategic asset allocation This type of allocation is usually done once every few




years, using simulation procedures to determine the li*ely range of outcomes associated with each mi'. The investor considers the range of outcomes for each mi', and chooses the preferred one, there%y esta%lishing a long-run, or strategic asset mi'. 2. Tactical asset allocation This type of allocation is performed routinely, as part of the ongoing process of asset management. Changes in asset mi'es are driven %y changes in predictions concerning asset returns. As predictions of the e'pected returns on stoc*s, %onds and other assets change, the percentages of these assets held in the portfolio changes. n effect, tactical asset allocation is a mar*et timing approach to portfolio management intended to increase e'posure to a particular mar*et when its performance is e'pected to %e good, and decrease e'posure when performance is e'pected to %e poor.


?iven the increased comple'ity in managing institutional portfolios, it is critical to esta%lish a well-defined and effective policy. Buch a policy must clearly delineate the o%+ectives %eing sought, the institutional investor#s ris* tolerance, and the investment constraints and preferences under which it must operate. The primary reason for esta%lishing a long-term investment policy for institutional investors is twofold8 ;1= ;2= it prevents ar%itrary revisions of a soundlydesigned investment policy/ it helps the portfolio manager to plan and e'ecute on a long-term %asis and resist shortterm pressures that could derail the plan.


There is no definitive answer to this 2uestion. -n the one hand, more recent years should generally %e more relevant to the current situation for o%vious reasons. )or e'ample, we have not had a Cepression since the 19>0s, and government interest rates were

held to artificial lows for many years. -n the other hand, the entire historical record from 192< should %e, on average, representative of a %road sweep of mar*et history and may indicate what investors, on average, can e'pect from stoc*s when various conditions are ta*en into account--wars, inflation, deflation, sta%ility, and so forth. C(A 2121<4 A. )"A!3&-"7 -DE3CT F3B C-5BT"A 5TB "eturn "is* Time (ori$on Gi2uidity 5eeds Ta' Considerations Gegal4"egulatory ssues Hni2ue 5eeds and Circumstances


A11G CAT -5 C ))3"35C3B 1ension )und &idow,s 1ortfolio Total "eturn -%+ective ncome-riented with Bome nflation 1rotection Bomewhat Delow-Average Company Dears "is* Capacity ndicated/ &idow %ears "is*/ Bafety mportant !edium Term/ Gife



A%ove-Average Capacity/

Time (ori$on )inite

Gong Term/

nfinite Gife


Gow/ Cash )low Accrues

1ro%a%ly !edium to (igh/ 5o "einvestment Gi*ely )ederal ;and 1ro%a%ly Btate= ncome Ta'es 1aid on !ost nvestment "eceipts I1rudent !anI "ule "egulatory ;)ederal= Applies ;Btate= &idow,s 5eeds Are mmediate And ?overn 5ow/ Children#s 5eeds Bhould De Considered in 1lanning for future


H.B. Ta'-3'empt


?overnment %y 3" BA

Hni2ue 5eeds Cash )low "einvested/ And Circumstances

C(A 212114 A. A useful framewor* that identifies and organi$es the re2uired inputs to an investment policy statement is the following8 -%+ectives "eturn re2uirement "is* tolerance Constraints Gi2uidity needs Time hori$on Ta' considerations Gegal and regulatory

considerations Hni2ue needs, circumstances and preferences D. The returns of a well-diversified portfolio ;within an asset class= are highly correlated with the returns of the asset class itself. -ver time, diversified portfolios of securities within an asset class tend to produce similar returns. n contrast, returns %etween different asset classes are often much less correlated, and over time, different asset classes are very li*ely to produce 2uite different returns. This e'pected difference in returns arising from differences in asset class e'posures ;i.e., from differences in asset allocation= is, thus, the *ey performance varia%le. Three reasons why successful implementation of asset allocation decisions is more difficult in practice than in theory are8 ;1= Transaction costs - investing or re%alancing a portfolio to reflect a chosen asset allocation is not cost-free/ e'pected %enefits are reduced %y the costs of implementation. Changes in 3conomic and !ar*et )actors changing economic %ac*grounds, changing mar*et price levels and changing relationships within and across asset classes all act to reduce the optimality of a given allocation decision and to create re2uirements for eventual re%alancing. Changes in economic and mar*et factors change the e'pected ris*4reward relationships of the allocation on a continuing %asis. Changes in nvestor )actors - the passage of time often gives rise to changes in investors needs, circumstances or preferences which, in turn, give rise to the need to reallocate, with the attendant costs of doing so.




n summary, even the 9perfect: asset allocation is altered %y the very act of implementation, due to transaction costs and4or changes in the original economic4mar*et conditions and, as time passes, changes in the investor#s situation. These impediments to successful implementation are inherent in the process, mandating ongoing monitoring of the relevant input factors. n practice, the fact of change in one or more of these factors is a 9given/: constant attention of the degree and the importance of the effects is re2uired. C(A 212124 A. The investment process itself is common to all managers everywhere. Bystematic e'ploitation of this underlying reality is as readily accomplished at a one-manager shop in which a hand-held calculator is used as it is %y an industry giant employing the latest in realtime, on-line, interactive computer systems. The dynamic is there, and it is useful and fundamental. The four *ey steps in the portfolio management process are8 1. dentify and specify the investor,s o%+ectives, preferences and constraints in order to develop e'plicit investment policies. Cevelop and implement strategies through the choice of optimal com%inations of financial and real assets in the mar*etplace. !onitor mar*et conditions, relative asset values and the investor,s circumstances. !a*e portfolio ad+ustments as appropriate to reflect significant changes in any or all of the relevant varia%les.


>. @.

1ortfolio management is a dynamic and continuous process with the four steps repeated again and again. D. "is*8 -%+ectives &hile a need e'ists to protect %oth the corpus and the income stream against inflation, the Doard of Trustees is 9conservative: and spending needs are continuous while gift income is 2uite varia%le. These circumstances argue for adoption of a non-aggressive, medium-ris* policy posture. Current income production of ade2uate proportions is clearly of ma+or importance here, mitigated to some e'tent %y the historical availa%ility of gift supplements to endowment returns. A 9spending rule: should %e formulated %y the Doard that ta*es inflation into account, and policy should state a preference for income over gain without, however, adopting an e'treme income orientation.


Constraints Time (ori$on8 The actual hori$on is clearly a very long one ;perpetual, in concept= %ut given the nature of the o%+ectives it would %e useful if the policy statement spo*e of, say, successive A-year planning hori$ons with some fairly definite 1-year su%-goals. Bince gifts are important %ut are 2uite a varia%le as well, a 12-1J month li2uidity reserve would %e

Gi2uidity 5eeds

appropriate here to provide for spending continuity and possi%ly emergency needs. The e'istence of such a reserve might allow the Doard to %e a %it more aggressive in its asset allocation overall. Ta' Considerations8 Aside from meeting whatever )ederal and Btate reporting re2uirements may e'ist, ta'es are a very minor matter here and should have no effect on investment policy. Gegal K "egulatory "e2uirements8

3'cept for re2uired conformity with the 1rudent !an "ule relating to investments, and to any humanrights type regulations that may impact policy, these considerations are minor in this case. The policy statement may wish to give some specific attention to pro'y-voting and li*e matters. The need to satisfy a conservative Doard and the wide variations in gift income must %e addressed in whatever policy statement is produced. These are easily accommodated, however, and should not disrupt normal investment action.

Hni2ue 5eeds K Circumstances8

C(A 212154 A. 1olicy statement. An investment policy statement for the )oote family is as follows8 9The )oote account should %e invested to achieve ma'imum after-ta', inflation-ad+usted, total return su%+ect to their ris* profile. Their su%stantial a%ility to tolerate ris* is

increased %y the long time hori$on and the a%sence of any need for li2uidity. The ta' implications favor focusing on long-term appreciation.: Hsing the o%+ectives constraints template, relevant policy considerations would include the following8 . . . "is* tolerance8 high "eturn o%+ectives8 high - ma'imum Ta'es8 important Gegal8 o%servance of appropriate law

Time hori$on8 long Gi2uidity needs8 small

")%tifi'ation4 The )ootes have said they do not e'pect to use the income or principal of the fund %efore their retirement, which is at least >0 years in the future. &ith such a long time hori$on, they have a ma'imum a%ility to accept uncertainty of returns and should see* the highest return given this high ris* tolerance. The return focus should %e 9total: with an after-ta' inflation-ad+usted emphasis. The )ootes do not need li2uidity, and the couple does not have any truly uni2ue limitations that would impose constraints on investment policy. The interests of the charita%le remainder do not conflict with those of the )ootes and should not constrain the policy developed a%ove. &ith significant passage of time or ma+or changes in client circumstances, a policy ad+ustment might %e necessary, %ut not at this point. D. The e'pected versus re2uired returns of the three funds as determined %y the security mar*et line are as follows8 )und A 3'pected 1<.AL "e2uired 1M.<L

)und D )und C

1>.0L J.0L

12.JL J.0L

Cetermining an appropriate allocation for the )oote family re2uires considering %oth the security mar*et line and the policy findings in 1art A. The policy statement in 1art A found the couple could tolerate high ris* and therefore could accept the higher %etas of )unds A and D. (owever, the re2uired returns of the security mar*et line must %e determined to ma*e a +udgment a%out the propriety of each fund. As the ta%le a%ove shows, )und A is an inefficient portfolio %ecause the e'pected returns are less than the re2uired returns. )und D would %e a %etter choice considering only the security mar*et line ;B!G=. f ta'es are considered and capital gains remain unreali$ed, )und A#s after-ta' rate of return would %e 1<.1 percent and )und D,s after-ta' rate of return would %e 11.J percent. Ta'es widen the return spread %etween A and D to @.> percent and can %e used to +ustify the inclusion of )und A. Decause )und D has > percent of its total 1> percent return from dividends, which are ta'ed at @0 percent, the after-ta' e'pected return in )und D drops from 1> percent to 11.J percent. A portfolio that uses more than one of the availa%le funds should still have a growth orientation. The use of )und C can %e +ustified only %y diversification or ris* reduction and should %e minimal given the high ris*4high return policy o%+ectives. C. The N>A0,000 inheritance is e'pected to achieve a 12 percent rate of return, or N@2,000, from its investment in the smallcapitali$ation portfolio. The improved return from leverage would %e the difference %etween the e'pected return, 12 percent, and the cost of %orrowing, J percent, or @ percent multiplied %y the incremental funds, N1A0,000, or N<,000. The leverage would improve the

total e'pected return from the portfolio and would, of course, impart additional ris* to the portfolio. C. The %orrowing is appropriate %ased upon the policy statement in 1art A. The fund has no li2uidity needs and can accept the volatility implicit in a 1.@ %eta %ecause of the long time hori$on.

C(A 212164 A. A policy statement for the (ope !inistries would read8 9The )oundation#s assets should %e invested in *eeping with the special re2uirements of its Charter and fiduciary laws to produce N90,000 of current income. Decause of the perpetual nature of the )oundation, consideration should %e given to protecting the value of the fund and the value of the future income stream from the effects of inflation. !oderate ris* may %e tolerated to achieve these o%+ectives. -nly minimal li2uidity is re2uired and ta'es are of no concern.: Hsing the o%+ectives and constraints template, the following .)%tifi'ation would %e appropriate8 "eturn o%+ectives8 N90,000 in current income and appreciation of income and asset value sufficient to offset e'pected inflation.

"is* tolerance8

!oderate %ecause the time hori$on is long and inflation poses a potential threat over time. Ta' e'empt.


Gegal constraints8

nclude the terms of the Charter, which re2uire all income to %e distri%uted and all appreciation, reali$ed or not, to %e retained ;ma*ing a total return approach inappropriate=, and the normal re2uirements of fiduciary law. 5ot a ma+or factor. The Charter re2uirements mentioned a%ove are relatively uni2ue.

Gi2uidity8 Hni2ue factors8


)und D and C A minimum of N90,000 in income must %e achieved under any accepta%le allocation. Decause the )oundation can tolerate moderate ris*, -mega could allocate N1,A00,000 %etween )und D and )und C. )or e'ample, %y investing N900,000 of the assets in )und C, the )oundation receives NM2,000 ;JL ' N900,000= of current income toward the re2uired N90,000 annual income. nvesting the remaining N<00,000 in )und D, which is also an efficient portfolio, produces income of N1J,000, ;>L ' N<00,000=. This allocation produces the re2uired N90,000 of income and would appreciate at a rate of N<0,000 annually ;10L ' N<00,000=. Therefore, if -mega e'pects inflation to e'ceed 2L, this allocation ;N900,000 to )und C and N<00,000 to )und D= would provide inflation protection up to @L ;N<0,0004N1,A00,000=. /n-e%ira0le Allo'ation% Allocating the endowment funds %etween H.B. Treasury %ills and )und C would lower the return and also lower the ris*. This approach is not allowed %y the 2uestion and is not recommended %ecause the )oundation can

tolerate a higher level of ris* than provided %y such an allocation. nvesting the entire amount in H.B. Treasury %ills, )und A or )und D would not achieve the )oundation,s o%+ective of earning N90,000 in annual income. . . . Treasury %ills would provide only N<0,000 ;@L ' N1,A00,000= in annual income. )und A would provide only N1A,000 ;1L ' N1,A00,000= in annual income. )und D would provide only N@A,000 ;>L ' N1,A00,000= in annual income.

)und A is an inefficient portfolio %ecause the re2uired return is 1M.<L ;."A O @L P 1.M ;12L - @L=0= %ut its e'pected return is 1<.A percent. Therefore, -mega should avoid allocating funds to this inefficient portfolio. nvesting the entire portfolio in )und C would provide no inflation protection %ecause all of the income must %e distri%uted for operations.