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Portfolio Construction, Management, & Protection , 5e, Robert A. Strong Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
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 (contd)
A
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
Semantics Indecision Subjectivity Multiple Beneficiaries Investment Policy versus Investment Strategy
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Semantics
Growth, income, return on investment, and risk mean different things to different people
Semantics (contd)
Indecision
Subjectivity
Multiple Beneficiaries
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
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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
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Portfolio Objectives
Preconditions Traditional Portfolio Objectives Special Situation of Tax-Free income Portfolio Objectives and Expected Utility
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Preconditions
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Stability of Principal
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Income
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Income (contd)
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Growth of Income
This objective often seeks to have the annual income increase by at least the rate of inflation
Requires some investment in equity securities
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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
The investor can defer taxes for many years by successful long-term growth stock investing
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28
(0)
Price Dividends Tax (28%) Cash flow $20.00 $0
(1)
$22.00 0 0 $0
(2)
$24.20 0 0 $0
(3)
$26.62 0 0 $0
(4)
$29.28 0 0 $29.28
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29.28 20 4 (1 R ) R 10.00%
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26.68 20 (1 R ) 4 R 7.47%
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(0)
Price Dividends Tax (28%) Cash Flow $20.00 $0
(1)
$20.60 1.40 0.39 $1.01
(2)
$21.22 1.44 0.40 $1.04
(3)
$21.85 1.49 0.42 $1.07
(4)
$22.51 1.53 0.43 $23.61
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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
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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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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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Secondary Objective
Stability of Principal Income Growth of Income Capital Appreciation
Stability of Principal
X
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
?
? = unusual combinations involving a need to tailor a portfolio to a very specific need. X = not applicable.
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Inconsistent Objectives Infrequent Objectives Portfolio Splitting Liquidity The Role of Cash
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Inconsistent Objectives
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Infrequent Objectives
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
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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
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Cash contributes to portfolio stability, especially during periods of rising interest rates Cash includes:
Currency Money market instruments
e.g., Treasury bills
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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
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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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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
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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
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