Chapter 3

Setting Portfolio Objectives

Portfolio Construction, Management, & Protection, 4e, Robert A. Strong

Copyright 2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

Todays put-off objectives reduce tomorrows

achievements.
Harry F. Banks

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

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
4

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
Successful selection of the investment managers to
implement policy
5

Why Setting
Objectives Can Be Difficult

Semantics
Indecision
Subjectivity
Multiple Beneficiaries
Investment Policy versus Investment
Strategy
6

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
7

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
8

Indecision

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

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?

10

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
11

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
12

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

13

Portfolio Objectives

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

14

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?
15

Traditional Portfolio
Objectives

Stability of Principal
Income
Growth of Income
Capital Appreciation

16

Traditional Portfolio Objectives

20
18

capital appreciation

expected return

16

small
company
stocks

14
12

large company stocks

10
intermediateterm
government
6
bonds

growth
of income

4
2

T-bills

long-term
corporate bonds
long-term
government bonds

inflation

stability
0 of principal
0

income
12

18

24

standard deviation (%)

30

36
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 (contd)

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 if he holds the note
to maturity

21

Income (contd)
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 (contd)

This objective often seeks to have the

annual income increase by at least the rate
of inflation

Requires some investment in equity

securities

Or, possibly, inflation-protected securities

such as TIPS
24

Growth of Income (contd)

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.
25

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.
26

Growth of Income (contd)

Example (contd)
$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

27

Capital Appreciation

The goal is for the portfolio to grow in

value rather than generate income

Appropriate for investors who have no

income needs

28

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
29

Capital Appreciation (contd)

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.
30

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.

31

Capital Appreciation (contd)

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

Tax (28%)

Cash flow

$0

$0

$0

$0

$29.28

Price

32

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%
33

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%
34

Capital Appreciation (contd)

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

35

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%
36

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%
37

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
38

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

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

and 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
Primary Objective
Secondary
Objective

Stability of
Principal

Growth of
Income

Capital
Appreciation

Stability of
Principal

Debt and
Preferred
Stock

Unacceptable
Goals

Short-term
debt

At least 40%
equity

Growth of
Income

Unacceptable
goals

Varies: often
> 40% equity

At least 75%
equity

Capital
Appreciation

Unacceptable
goals

At least 75%
equity

Income

Income

? = unusual combinations involving a need to tailor a portfolio to a very specific need.

X = not applicable.

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
The use of TIPS could also be a possibility
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 (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

50

Portfolio Dedication

Introduction
Cash Matching
Duration Matching

51

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
52

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
53

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
54

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
55

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
56