Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Chapter 26 The Process of Portfolio Management 26-1

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh ObjectivesConstraintsPolicies Return RequirementsLiquidityAsset Allocation Risk ToleranceHorizonDiversification RegulationsRisk Positioning TaxesTax Positioning Unique NeedsIncome Generation Determinants of Portfolio Policies 26-2

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Type of InvestorReturn Requirement Risk Tolerance Individual and Personal TrustsLife Cycle Life Cycle Mutual FundsVariable Variable Pension FundsAssumed actuarial rate Depends on payouts Endowment FundsDetermined by income Generally needs and asset growth conservative to maintain real value Matrix of Objectives 26-3

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Type of InvestorReturn Requirement Risk Tolerance Life InsuranceSpread over cost of Conservative funds and actuarial rates Nonlife Ins. Co. No minimum Conservative BanksInterest Spread Variable Matrix of Objectives (cont’d) 26-4

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Type of Investor Individual investor: Life cycle stage and individual preference Personal Trusts: Usually a Bank, saving and loan association; more risk averse Endowments: Use money for non-profit purpose; moderate risk taker 26-5

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Type of Investor (cont’d) Life Insurance Companies: hedge their liability defined by their policy Non-life insurance companies: Property and casualty insurance; typically conservative attitude towards risk Banks: Matching the risk of assets to liabilities 26-6

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Liquidity –Ease (speed) with which an asset can be sold and created into cash –Relationship between time dimension and price dimension –Need to establish the minimum level of liquid assets in the investment portfolio Investment horizon – planned liquidation date of the investment or part of it Constraints on Investment Policies 26-7

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Constraints on Investment Policies Regulations –Prudent investor law: for professional investors –Specific regulations for institutional investors. Tax considerations: – Tax sheltering –Deferral of tax obligations Unique needs 26-8

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Constraints on Investment Policies Unique needs –Nature of employment –Stage of the life cycle –Institutional investors: pension fund and average age of the plan participant 26-9

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Asset Allocation Specify the asset class Specify the capital market expectations –Determining your expected rate of return over the relevant holding period Derive the efficient market frontier Find the optimal asset mix Policy statement 26-10

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Taxes After tax holding period return: has several complications because –Choice between tax-exempt and taxable bonds –HPR in the form of capital gain or loss –Timing the sale for capital gain tax purposes –After tax HPR and dividend payout policy of corporation 26-11

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Managing Portfolios of Individual Investors Overriding consideration is life cycle –Human capital and insurance: the first significant investment decision Investment in residence: the first major economic asset –Hedge against risk of increase in rental value –Availability is guaranteed Saving for retirement and assumption of risk: Shift in risk attitude –Retirement planning model 26-12

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Managing Yourself or Relying on Others Managing own portfolio: a low cost solution Fees and charges of financial planner verse value of your own time Potential differences in investment results 26-13

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Challenges for Professional Managers Communication gap: getting clients to communicate their objectives and constraints: not a one time task Keeping the clients abreast of the outcome 26-14

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Tax Sheltering for Individual Investors Tax-deferral option –controlling the timing of tax payment Tax-deferred retirement plans: Contributions and earnings are not subject to tax until the individual has withdrawn those as benefits –IRAs –Keogh plans 26-15

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Tax Sheltering for Individual Investors (cont’d) Deferred annuities: Tax sheltered account offered by life insurance companies –Option to withdraw one’s funds in the form of life annuity and even mutual fund investing –Life long payment Fixed: pays fixed nominal sum of money per period Variable: payment linked to performance of investment 26-16

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Variable and Universal Life Insurance Variable life insurance: combines life insurance with tax-deferred annuity –Single or series of premium –Death benefit may rise but never fall –No tax on death benefit for the surviving beneficiary –Ability to borrow against the cash surrender value 26-17

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Universal Life Insurance Policy Similar to variable life policy except that the rate of return is determined by the insurance company Rate will change with the market Rates vary across companies: Choose the best!! 26-18

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Pension or Super Funds Most common: employer sponsored pension plan Pension fund is cumulation of assets created from contributions and earnings on those contributions Tax implications for the employer and employee’s contribution 26-19

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Pure Types of Plans: Defined Contribution Plans Defined contribution plans: –contribution specified as a predetermined fraction of salary but not the benefit payment –Fraction need not be constant –At retirement employee may purchase an annuity –Contributions can be invested in any security –Employee bears all investment risk 26-20

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Pure Types of Plans: Defined Contribution Plans Investment policy is same as that of a tax qualified individual retirement account Main providers of investment products: mutual funds and insurance companies Setting and achieving the income replacement goal falls on employee, mainly 26-21

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Pure Types of Plans: Defined Benefit Plans Benefit specified but not the manner including the contributions The employer or an insurance company guarantees the benefit Guarantor absorbs the investment risk 26-22

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Defined Contribution vs. Defined Benefit Plan The two plan types are not mutually exclusive Employers adopt defined benefit plans (as primary plan where participation is compulsory) and supplement with voluntary defined contribution plan The plan is fully funded for defined contribution, but not in case of defined benefit plan 26-23

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Pension Investment Strategies Defined contribution plan –Participant bears the investment risk –Optimal asset mix depends on the risk tolerance of the participant Defined benefit –Sponsor/employer absorbs the investment risk –Incentive to eliminate investment risk by investing in securities that match the promised benefits Immunisation of pension liability Contingent immunisation 26-24

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Pension Investment Strategies Investing in equities!! –100% bond investment minimises the cost of guaranteeing the defined benefit –Tax disadvantage with equity: lower tax rate on dividend along with the deferral of capital gain tax lowers the tax shield for the corporate But pension funds invest 40%-60% of their portfolio in equity 26-25

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Why Equity? Equity will allow to pay extra benefit to employees Through superior market timing and security selection it is possible to create value Financially distressed firms will have an incentive to invest pension fund money in the riskiest asset 26-26

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Wrong Reason to go for Equity Interrelated fallacies –Stocks are not risky in the long run –Stocks are hedge against inflation: empirical finding show that stock returns are negatively correlated with inflation and in the best of circumstances offer a limited hedge against inflation 26-27

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Future Trends in Portfolio Management Enormous growth in the amount of money invested in mutual funds in US –Introduction of tax-deferred retirement saving plan by employers –Dramatic rise in stock prices Whither portfolio management in future? 26-28

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Future Trends in Portfolio Management Increased use of inflation-indexed bonds –Specially attractive to risk averse investors Growth in Pension funds as substitutes for mutual funds: –Internet enabled the firms to offer personalised funds at cost competitive with mutual funds –Pension funds overcome some drawbacks of mutual funds More direct management of funds by individuals More companies offering structured financial products 26-29

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Summary Most institutional investors match the risk return characteristics of their investment portfolio with characteristics of their liability Effectiveness of an asset as an inflation hedge is related to its correlation with unanticipated inflation Investment strategies designed to avoid taxes may contradict the principles of efficient diversification 26-30

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Summary: (cont’d) Life cycle approach to management of an individual’s investment portfolio Life and disability insurance hedge against the loss of human capital or future earning power Sheltering investment income from the taxes: investing in assets where return are in the form of appreciation of value, tax deferred retirement plans or tax advantaged products offered by life insurance industry 26-31