Upload
dr-singh
View
221
Download
0
Embed Size (px)
Citation preview
8/3/2019 Portfolio Management - Chapter 4
1/55
Chapter 4
Setting Portfolio Objectives
Prof. Rushen Chahal 1
Prof. Rushen Chahal
8/3/2019 Portfolio Management - Chapter 4
2/55
Todays put-off objectives reduce tomorrows
achievements.
- Harry F. Banks
Prof. Rushen Chahal 2
8/3/2019 Portfolio Management - Chapter 4
3/55
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
Prof. Rushen Chahal 3
8/3/2019 Portfolio Management - Chapter 4
4/55
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 return15% annually for next ten year
Prof. Rushen Chahal 4
8/3/2019 Portfolio Management - Chapter 4
5/55
Introduction (contd)
Pension and Investments article states
importance of setting portfolio objectives:
Two factors contribute to a sponsors successfulinvestment program:
Suitable investment objectives and policy
Successful selection of the investment managers toimplement policy
Prof. Rushen Chahal 5
8/3/2019 Portfolio Management - Chapter 4
6/55
Why Setting
Objectives Can Be Difficult Semantics
Indecision
Subjectivity Multiple beneficiaries
Investment policy versus investment strategy
Prof. Rushen Chahal 6
8/3/2019 Portfolio Management - Chapter 4
7/55
Semantics
Growth,income,return on investment, andriskmean different things to differentpeople
E.g., a savings account provides income only; ithas no growth potential
There must be a clear understanding of the
terms when entrusting money to a fundmanager
Prof. Rushen Chahal 7
8/3/2019 Portfolio Management - Chapter 4
8/55
Semantics (contd)
Interpretation ofPrincipaland 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
Prof. Rushen Chahal 8
8/3/2019 Portfolio Management - Chapter 4
9/55
Indecision
The clients inability to make a decision
E.g., a bank customer wants to have interestcompounded but have the interest send
home each month
Prof. Rushen Chahal 9
8/3/2019 Portfolio Management - Chapter 4
10/55
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?
Prof. Rushen Chahal 10
8/3/2019 Portfolio Management - Chapter 4
11/55
Multiple Beneficiaries
Investment portfolios often have more than onebeneficiary
E.g., an endowment fund has a perpetual life
It is possible to increase current income from theportfolio
Benefits todays beneficiaries
May be at the expense of futures beneficiaries E.g.,Social Security and federal unemployment
insurance
Prof. Rushen Chahal 11
8/3/2019 Portfolio Management - Chapter 4
12/55
Investment Policy Versus
I
nvestment Strategy Investment policydeals 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
Prof. Rushen Chahal 12
8/3/2019 Portfolio Management - Chapter 4
13/55
Investment Policy Versus
I
nvestment Strategy (contd) Investment strategydeals 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
Prof. Rushen Chahal 13
8/3/2019 Portfolio Management - Chapter 4
14/55
Portfolio Objectives
Preconditions
Traditional portfolio objectives
Tax-free income generation
Portfolio objectives and expected utility
Prof. Rushen Chahal 14
8/3/2019 Portfolio Management - Chapter 4
15/55
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 bythe funds owner or overseer?
Prof. Rushen Chahal 15
8/3/2019 Portfolio Management - Chapter 4
16/55
Traditional Portfolio Objectives
Stability of principal
Income
Growth of income
Capital appreciation
Prof. Rushen Chahal 16
8/3/2019 Portfolio Management - Chapter 4
17/55
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
Prof. Rushen Chahal 17
8/3/2019 Portfolio Management - Chapter 4
18/55
Stability of Principal (contd)
Appropriate investment vehicles:
Bank certificates of deposit
Other money market instruments
Prof. Rushen Chahal 18
8/3/2019 Portfolio Management - Chapter 4
19/55
Assessing
T
ax-Exempt Bonds
Prof. Rushen Chahal 19
8/3/2019 Portfolio Management - Chapter 4
20/55
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
Prof. Rushen Chahal 20
8/3/2019 Portfolio Management - Chapter 4
21/55
Income (contd)
Appropriate investment vehicles:
Corporate bonds
Government bonds
Government agency securities
Preferred stock
Common stock
Prof. Rushen Chahal 21
8/3/2019 Portfolio Management - Chapter 4
22/55
Growth ofIncome
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
Prof. Rushen Chahal 22
8/3/2019 Portfolio Management - Chapter 4
23/55
Growth ofIncome (contd)
Often seek to have the annual income
increase by at least the rate of inflation
Requires some investment in equity
securities
Prof. Rushen Chahal 23
8/3/2019 Portfolio Management - Chapter 4
24/55
Growth ofIncome (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 nextten years.
Portfolio A has an income objective and seeks to providemaximum income each year. The portfolio is invested 100% indebt securities. Thus, Portfolio A generates $5,000 in incomeeach year.
Prof. Rushen Chahal 24
8/3/2019 Portfolio Management - Chapter 4
25/55
Growth ofIncome (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 tenyears is shown graphically on the following slide.
Prof. Rushen Chahal 25
8/3/2019 Portfolio Management - Chapter 4
26/55
Growth ofIncome (contd)
Example (contd)
Prof. Rushen Chahal 26
$5,000
$6,180
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
1999 2001 2003 2005 2007 2009
Portfolio A
Portfolio B
8/3/2019 Portfolio Management - Chapter 4
27/55
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
Prof. Rushen Chahal 27
8/3/2019 Portfolio Management - Chapter 4
28/55
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
Prof. Rushen Chahal 28
8/3/2019 Portfolio Management - Chapter 4
29/55
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%.
Prof. Rushen Chahal 29
8/3/2019 Portfolio Management - Chapter 4
30/55
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 IRRcalculations are shown
on the next slides.
Prof. Rushen Chahal 30
8/3/2019 Portfolio Management - Chapter 4
31/55
Capital Appreciation (contd)
Prof. Rushen Chahal 31
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
8/3/2019 Portfolio Management - Chapter 4
32/55
Capital Appreciation (contd)
Example (contd)
If the investor does not sell Investment A after four years,
his after-tax internal rate of return is:
Prof. Rushen Chahal 32
4
29.2820
(1 )
10.00%
R
R
!
!
8/3/2019 Portfolio Management - Chapter 4
33/55
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:
Prof. Rushen Chahal 33
426.6820
(1 )
7.47%
R
R
!
!
8/3/2019 Portfolio Management - Chapter 4
34/55
Capital Appreciation (contd)
Prof. Rushen Chahal 34
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
8/3/2019 Portfolio Management - Chapter 4
35/55
Capital Appreciation (contd)
Example (contd)
If the investor does not sell Investment B after four years,
his after-tax internal rate of return is:
Prof. Rushen Chahal 35
2 3 4
1.01 1.04 1.07 23.61
20 (1 ) (1 ) (1 ) (1 )
8.04%
R R R R
R
!
!
8/3/2019 Portfolio Management - Chapter 4
36/55
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:
Prof. Rushen Chahal 36
2 3 41.01 1.04 1.07 22.9120 (1 ) (1 ) (1 ) (1 )
7.29%
R R R R
R
!
!
8/3/2019 Portfolio Management - Chapter 4
37/55
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 incomestrategy
Invest in a mix of municipal bonds and common
stock for a growth-of-income strategy
Prof. Rushen Chahal 37
8/3/2019 Portfolio Management - Chapter 4
38/55
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
Prof. Rushen Chahal 38
8/3/2019 Portfolio Management - Chapter 4
39/55
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 causediscomfort
Utility comes from quantifiable andnonquantifiable sources
E.g., an investor may choose his own stocks rather than
investing in mutual funds for the thrill of the hunt
Prof. Rushen Chahal 39
8/3/2019 Portfolio Management - Chapter 4
40/55
The Importance of Primary &
Secondary Objectives
Introduction
Possible combinations of objectives
Prof. Rushen Chahal 40
8/3/2019 Portfolio Management - Chapter 4
41/55
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)
Prof. Rushen Chahal 41
8/3/2019 Portfolio Management - Chapter 4
42/55
Possible Combinations of
Objectives
Prof. Rushen Chahal 42
Primary Objective
Secondary
Objective
Stability of
Principal Income
Growth of
Income
Capital
Appreciation
Stability ofPrincipal
X Debt andPreferred
Stock
UnacceptableGoals
?
Income Short-term
debt
X At least 40%
equity
?
Growth ofIncome
Unacceptablegoals
Varies: often> 40% equity
X At least 75%equity
Capital
Appreciation
Unacceptable
goals
? At least 75%
equity
X
8/3/2019 Portfolio Management - Chapter 4
43/55
Other Factors to Consider In
Establishing Objectives
Inconsistent objectives
Infrequent objectives
Portfolio splitting Liquidity
The role of cash
Prof. Rushen Chahal 43
8/3/2019 Portfolio Management - Chapter 4
44/55
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
Prof. Rushen Chahal 44
8/3/2019 Portfolio Management - Chapter 4
45/55
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 tomaturity
Prof. Rushen Chahal 45
8/3/2019 Portfolio Management - Chapter 4
46/55
Portfolio Splitting
A fund manager receives instructions thatrequire that the portfolio be managed inmore 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, overallobjective
Prof. Rushen Chahal 46
8/3/2019 Portfolio Management - Chapter 4
47/55
Liquidity
Liquidityis 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 withcheck-writing privileges
Prof. Rushen Chahal 47
8/3/2019 Portfolio Management - Chapter 4
48/55
The Role of Cash
Investment management firms routinelyprescribe portfolio proportions for:
Equity securities
Fixed-income securities
Cash
Arrives in portfolios naturally though the receipt ofdividends and interest
Prof. Rushen Chahal 48
8/3/2019 Portfolio Management - Chapter 4
49/55
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
Prof. Rushen Chahal 49
8/3/2019 Portfolio Management - Chapter 4
50/55
Portfolio Dedication
Introduction
Cash matching
Duration matching
Prof. Rushen Chahal 50
8/3/2019 Portfolio Management - Chapter 4
51/55
Introduction
Portfolio dedication (liability funding)involves managing an asset portfolio so thatit services the requirements of a
corresponding liability or portfolio ofliabilities
Overlays the primary and secondary investmentobjectives
The two principal methods are cash matchingand duration matching
Prof. Rushen Chahal 51
8/3/2019 Portfolio Management - Chapter 4
52/55
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
Prof. Rushen Chahal 52
8/3/2019 Portfolio Management - Chapter 4
53/55
DurationMatching
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
Prof. Rushen Chahal 53
8/3/2019 Portfolio Management - Chapter 4
54/55
DurationMatching (contd)
In a duration-matched portfolio:
A rise in interest rates results in a decline in theportfolios value that is approximately offset by
additional income earned from the higherreinvestment rate
A fall in interest rates results in a decline inincome from reinvested funds that is
approximately offset by the increase in themarket value of the portfolio
Prof. Rushen Chahal 54
8/3/2019 Portfolio Management - Chapter 4
55/55
DurationMatching (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
Prof Rushen Chahal 55