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Chapter 4 Setting Portfolio Objectives

Chapter 4 Setting Portfolio Objectives

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Chapter 4 Setting Portfolio Objectives

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  1. Chapter 4Setting Portfolio Objectives

  2. Today’s put-off objectives reduce tomorrow’s achievements. - Harry F. Banks

  3. 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

  4. 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 return 15% annually for next ten year

  5. Introduction (cont’d) • Pension and Investments article states 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

  6. Why Setting Objectives Can Be Difficult • Semantics • Indecision • Subjectivity • Multiple beneficiaries • Investment policy versus investment strategy

  7. 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

  8. 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

  9. Indecision • The client’s inability to make a decision • E.g., a bank customer wants to have interest compounded but have the interest send home each month

  10. 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?”

  11. 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 futures beneficiaries • E.g., Social Security and federal unemployment insurance

  12. 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 categories • E.g., a pension fund decides never to place more than 30% in common stock

  13. 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 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

  14. Portfolio Objectives • Preconditions • Traditional portfolio objectives • Tax-free income generation • Portfolio objectives and expected utility

  15. 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?

  16. Traditional Portfolio Objectives • Stability of principal • Income • Growth of income • Capital appreciation

  17. 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

  18. Stability of Principal (cont’d) • Appropriate investment vehicles: • Bank certificates of deposit • Other money market instruments

  19. Assessing Tax-Exempt Bonds

  20. 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

  21. Income (cont’d) • Appropriate investment vehicles: • Corporate bonds • Government bonds • Government agency securities • Preferred stock • Common stock

  22. 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

  23. Growth of Income (cont’d) • Often seek to have the annual income increase by at least the rate of inflation • Requires some investment in equity securities

  24. 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% 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% in debt securities. Thus, Portfolio A generates $5,000 in income each year.

  25. 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 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 ten years is shown graphically on the following slide.

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

  27. 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

  28. 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

  29. Capital Appreciation (cont’d) 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%.

  30. Capital Appreciation (cont’d) Example (cont’d) 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 IRR calculations are shown on the next slides.

  31. Capital Appreciation (cont’d)

  32. 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:

  33. 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:

  34. Capital Appreciation (cont’d)

  35. 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:

  36. 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:

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

  38. Tax-Free Income Generation (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

  39. 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”

  40. The Importance of Primary & Secondary Objectives • Introduction • Possible combinations of objectives

  41. 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)

  42. Possible Combinations of Objectives

  43. Other Factors to Consider In Establishing Objectives • Inconsistent objectives • Infrequent objectives • Portfolio splitting • Liquidity • The role of cash

  44. 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”

  45. 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

  46. 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

  47. 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

  48. 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

  49. 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

  50. Portfolio Dedication • Introduction • Cash matching • Duration matching