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Chapter 3

Setting Portfolio Objectives

Portfolio Construction, Management, & Protection , 5e, Robert A. Strong Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

Todays put-off objectives reduce tomorrows achievements. Harry F. Banks


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

Introduction (contd)

Pension and Investments article states the importance of setting portfolio objectives:
Two factors contribute to a sponsors successful investment program:
Suitable investment objectives and policy

Successful selection of the investment managers to implement policy


Why Setting Objectives Can Be Difficult

Semantics Indecision Subjectivity Multiple Beneficiaries Investment Policy versus Investment Strategy


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

Semantics (contd)

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


The clients inability to make a decision

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


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?

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 todays beneficiaries May be at the expense of future beneficiaries e.g., Social Security and federal unemployment insurance

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

Investment Policy versus Investment Strategy (contd)

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


Portfolio Objectives

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



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 funds owner or overseer?

Traditional Portfolio Objectives

Stability of Principal Income Growth of Income Capital Appreciation


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


Stability of Principal (contd)

Appropriate investment vehicles:

Bank certificates of deposit

Other money market instruments



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


Income (contd)

Appropriate investment vehicles:

Corporate bonds Government bonds Government agency securities Preferred stock Common stock


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

Growth of Income (contd)

This objective often seeks to have the annual income increase by at least the rate of inflation
Requires some investment in equity securities


Growth of Income (contd)

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.

Growth of Income (contd)

Example (contd)
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.

Growth of Income (contd)

Example (contd)
$7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 2005 2007 2009 2011 2013 2015

$6,180 $5,000 Portfolio A Portfolio B

Capital Appreciation

The goal is for the portfolio to grow in value rather than generate income Appropriate for investors who have no income needs


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

Capital Appreciation (contd)

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.

Capital Appreciation (contd)

Example (contd)
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.


Capital Appreciation (contd)

Investment A (no dividends) 10% Pretax Annual Return

Price Dividends Tax (28%) Cash flow $20.00 $0

$22.00 0 0 $0

$24.20 0 0 $0

$26.62 0 0 $0

$29.28 0 0 $29.28

Capital Appreciation (contd)

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

29.28 20 4 (1 R ) R 10.00%

Capital Appreciation (contd)

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:

26.68 20 (1 R ) 4 R 7.47%

Capital Appreciation (contd)

Investment B (7% dividend yield) 10% Pretax Annual Return

Price Dividends Tax (28%) Cash Flow $20.00 $0

$20.60 1.40 0.39 $1.01

$21.22 1.44 0.40 $1.04

$21.85 1.49 0.42 $1.07

$22.51 1.53 0.43 $23.61

Capital Appreciation (contd)

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

1.01 1.04 1.07 23.61 20 2 3 4 (1 R ) (1 R) (1 R) (1 R) R 8.04%


Capital Appreciation (contd)

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:

1.01 1.04 1.07 22.91 20 2 3 4 (1 R ) (1 R) (1 R) (1 R) R 7.29%


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

Special Situation of Tax-Free Income (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


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

The Importance of Primary and Secondary Objectives

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)

Possible Combinations of Objectives

Primary Objective

Secondary Objective
Stability of Principal Income Growth of Income Capital Appreciation

Stability of Principal

Income Debt and Preferred Stock X Varies: often > 40% equity ?

Growth of Income
Unacceptable Goals At least 40% equity X At least 75% equity

Capital Appreciation

Short-term debt Unacceptable goals Unacceptable goals

? At least 75% equity X

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


Other Factors to Consider in Establishing Objectives

Inconsistent Objectives Infrequent Objectives Portfolio Splitting Liquidity The Role of Cash


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


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

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


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

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

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

Portfolio Dedication

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

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

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

Duration Matching (contd)

In a duration-matched portfolio:
A rise in interest rates results in a decline in the portfolios 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

Duration Matching (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