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.
1
Today’s put-off objectives reduce tomorrow’s
achievements.
Harry F. Banks
2
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
3
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
4
Why Setting
Objectives Can Be Difficult





Semantics
Indecision
Subjectivity
Multiple Beneficiaries
Investment Policy versus Investment
Strategy
5
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
6
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
7
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
8
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?”
9
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
10
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
11
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
12
Portfolio Objectives




Preconditions
Traditional Portfolio Objectives
Special Situation of Tax-Free income
Portfolio Objectives and Expected Utility
13
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?
14
Traditional Portfolio
Objectives




Stability of Principal
Income
Growth of Income
Capital Appreciation
15
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
16
Stability of Principal (cont’d)
Appropriate investment vehicles:

•
Bank certificates of deposit
•
Other money market instruments
17
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
18
Income (cont’d)
Appropriate investment vehicles:

•
•
•
•
•
Corporate bonds
Government bonds
Government agency securities
Preferred stock
Common stock
19
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
20
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
21
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.
22
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.
23
Growth of Income (cont’d)
Example (cont’d)
$7,000
$6,180
$6,000
$5,000
$5,000
$4,000
Portfolio A
Portfolio B
$3,000
$2,000
$1,000
$0
2005 2007 2009 2011 2013 2015
24
Capital Appreciation

The goal is for the portfolio to grow in
value rather than generate income

Appropriate for investors who have no
income needs
25
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
26
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.
27
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.
28
Capital Appreciation (cont’d)
Investment A (no dividends)
10% Pretax Annual Return
Year
(0)
(1)
(2)
(3)
(4)
$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
Price
29
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:
29.28
20 
(1  R) 4
R  10.00%
30
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:
26.68
20 
(1  R) 4
R  7.47%
31
Capital Appreciation (cont’d)
Investment B (7% dividend yield)
10% Pretax Annual Return
Year
(0)
(1)
(2)
(3)
(4)
$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
Price
32
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:
1.01
1.04
1.07
23.61
20 



2
3
(1  R) (1  R)
(1  R)
(1  R) 4
R  8.04%
33
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:
1.01
1.04
1.07
22.91
20 



2
3
(1  R) (1  R)
(1  R)
(1  R) 4
R  7.29%
34
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
35
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
36
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”
37
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)
38
Possible Combinations of
Objectives
Primary Objective
Secondary
Objective
Stability of
Principal
Growth of
Income
Capital
Appreciation
Stability of
Principal
X
Debt and
Preferred
Stock
Unacceptable
Goals
?
Short-term
debt
X
At least 40%
equity
?
Growth of
Income
Unacceptable
goals
Varies: often
> 40% equity
X
At least 75%
equity
Capital
Appreciation
Unacceptable
goals
?
At least 75%
equity
X
Income
Income
? = unusual combinations involving a need to tailor a portfolio to a very specific need.
X = not applicable.
39
Other Factors to Consider in
Establishing Objectives





Inconsistent Objectives
Infrequent Objectives
Portfolio Splitting
Liquidity
The Role of Cash
40
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”
41
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
42
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
43
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
44
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
45
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
46
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
47
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
48
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
49
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
50
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
51