Chapter 4

Setting Portfolio Objectives

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Todays put-off objectives reduce tomorrows
achievements.

- Harry F. Banks

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 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
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 Introduction
Settingobjectives 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
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 Introduction (contd)
Pensionand Investments article states
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

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 Why Setting
Objectives Can Be Difficult
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
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
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 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

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 Indecision
The clients inability to make a decision

E.g., a bank customer wants to have

interest compounded but have the interest
send home each month

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 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?

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

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 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 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

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

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 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 funds owner or overseer?

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 Traditional Portfolio
Objectives
Stability of principal
Income
Growth of income
Capital appreciation

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 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

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Stability of Principal (contd)
Appropriate investment vehicles:
Bank certificates of deposit

Other money market instruments

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 Assessing
Tax-Exempt Bonds

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 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

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 Income (contd)
Appropriate investment vehicles:
Corporate bonds
Government bonds
Government agency securities
Preferred stock
Common stock

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 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

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 Growth of Income (contd)
Often seek to have the annual income
increase by at least the rate of inflation

Requires some investment in equity

securities

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 Growth of Income (contd)
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.
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 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 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.
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 Growth of Income (contd)
Example (contd)
$7,000
$6,180
$6,000
$5,000 $5,000

$4,000
Portfolio A
$3,000 Portfolio B
$2,000
$1,000
$0
1999 2001 2003 2005 2007 2009
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 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

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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

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 Capital Appreciation (contd)
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%.

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 Capital Appreciation (contd)
Example (contd)

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.

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 Capital Appreciation (contd)
Investment A (no dividends)
10% Pretax Annual Return
Year
0 1 2 3 4
Price $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
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 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
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(1 R) 4
R 10.00%
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 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
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(1 R) 4
R 7.47%
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 Capital Appreciation (contd)
Investment B (7% dividend yield)
10% Pretax Annual Return
Year
0 1 2 3 4
Price $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
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 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

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(1 R) (1 R) 2
(1 R) 3
(1 R) 4
R 8.04%
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 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
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(1 R) (1 R) 2
(1 R) 3
(1 R) 4
R 7.29%
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 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

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 Tax-Free Income Generation
(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

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 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

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The Importance of Primary &
Secondary Objectives
Introduction
Possible combinations of objectives

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 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)
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 Possible Combinations of
Objectives
Primary Objective
Secondary Stability of Growth of Capital
Objective Principal Income Income Appreciation
Stability of X Debt and Unacceptable ?
Principal Preferred Goals
Stock
Income Short-term X At least 40% ?
debt equity
Growth of Unacceptable Varies: often X At least 75%
Income goals > 40% equity equity
Capital Unacceptable ? At least 75% X
Appreciation goals equity
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 Other Factors to Consider In
Establishing Objectives
Inconsistent objectives
Infrequent objectives
Portfolio splitting
Liquidity
The role of cash

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 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

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 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

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 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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 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
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 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
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 Portfolio Dedication
Introduction
Cash matching
Duration matching

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 Introduction
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 billsassociated 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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 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

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 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

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