Core Fixed-Income Objectives - J.K. LASSER PRO

There are four fundamental objectives that all investors expect from the fixed-income portion of their portfolio:

1. Return of principal

2. A predictable income stream 3. Minimized market price fluctuations 4. Liquidity

Of these four objectives, return of principal is the top priority. Obviously, because fixed-income securities are really debt instruments whereby one party lends money to another, the credit quality of the borrower and the abil- ity of that borrower to repay is the most significant consideration. Within the core, the lowest-risk fixed-income securities often are debt instruments with short and intermediate maturity ranges and high credit quality ratings.

Because an objective is not to maximize capital appreciation within this segment of the portfolio, absent are high-yield bonds, emerging market debt, and other fixed-income securities with enhancement options. Portfolio managers typically concentrate more on credit quality than yield; they create broadly diversified portfolios with multiple holdings, thereby increasing the odds of preserving the principal value of the portfolio.

The predictability of the income stream, while primarily dependent upon the credit quality of the borrower, is also dependent upon the length of the maturity of the securities. While it is common for longer-term bonds to pay a higher rate of interest than shorter-term bonds, there is little to be gained by extending maturities beyond the intermediate maturity range since the higher market risks of the longer-term bonds are not offset by a significant or proportional increase in income. For the core portion of the fixed-income 122 THE PROCESS

portfolio, it is much more desirable to sacrifice minimal amounts of income in return for less market price volatility. Portfolio managers of core fixed- income portfolios generally understand that the future level of interest rates cannot be predicted with any significant level of accuracy. As a result, the desire for maximum income generation must be compromised with the desire for lower risk and volatility.

All fixed-income securities are subject to market price fluctuations, which are caused by two circumstances: (1) changing interest rates and (2) changing credit quality. Because a primary purpose of the fixed-income portion of the core portfolio is to reduce overall portfolio risk, a common strategy is to pur- chase only investment-grade short- and intermediate-term fixed-income securities. Even though these securities will never be the highest-yielding securities available, they will satisfy the objective of minimizing price volatility. In addition, this strategy naturally supports the other two goals of pro- tecting principal and providing stable income because of the inherent nature of the securities themselves.

Another risk that must be controlled is reinvestment risk. Because it is impossible to predict future interest rates or lock in current high yields for long periods of time without incurring excessive market price risk, a short or intermediate laddering strategy is often employed within the core portion of the fixed-income portfolio.

This accomplishes the objective of providing relatively high income while also affording the opportunity to take advantage of future interest rate changes as additional liquidity is generated by both coupon payments and maturing bonds. By staying within the short or intermediate time frames, the portfolio is able to capitalize on opportunities presented by advantageous interest rate changes rapidly while also avoiding significant pitfalls from neg- ative interest rate movements. With a laddered bond portfolio, it is also easy to match the risk profile of the portfolio with the risk tolerance of an investor merely by managing the average maturity of the portfolio.

Finally, acceptable liquidity parameters are required of the fixed-income portion of the core portfolio. In times of investor economic needs, the first source of liquidity is often the fixed-income securities because the chances of having to realize a loss are less. In addition, income payments may have been reinvested regularly, resulting in more availability of liquid funds. An investment’s liquidity is directly related to the size of the market and the number of participants in that market. U.S. Treasury notes are very liquid, while below-investment-grade corporate bonds have much less liquidity. As a result, one of the attributes of the core fixed-income portfolio is that it comprises a collection of high-quality securities diversified across many Building a Core Investment Portfolio 123

industry sectors, maturity ranges, and coupon yields, all with high degrees of liquidity.

Summary

When attempting to create the core portfolio with separate account managers, the challenge is to select either individual managers who embody an investment style representative of core or a combination of managers whose portfolios collectively meet the objective of core. Of course, this is dependent upon the size of the overall portfolio—larger portfolios will permit multiple managers, and the smaller ones will require the identification of one or two managers who can satisfy the objective. The important point to remember is that whatever investment managers are selected, their investment style and discipline must be capable of instilling in both the investor and the financial advisor the confidence necessary to conclude that the assets placed in their hands are representative of a core portfolio.

If properly constructed, the core can form the foundation of the total investment portfolio and should meet your client’s general investment objectives. It should be the first place an investor looks for comfort and security and the last place that causes an investor anxiety or panic. It will form the base from which all other more aggressive noncore investment strategies can be launched, and at the same time, serve as the safety net to which long-term investors can retreat in times of economic or financial turmoil.

In Chapter 10, you will learn how to write an investment policy statement that will do more to assure the success of your investment program than any other steps you take.

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C H A P T E R

10 The Creative Process of Writing an Investment Policy Statement

T

he creation of an investment policy statement is representative of a fundamental task that all investors should undertake. It should be an overid- ing objective of every financial advisor who is working in the separate account arena to have an investment policy statement for all of his/her clients.

A common mistake advisors make is that they simply don’t take time to write an investment policy statement. Or they write vague investment policies that state the obvious without giving managers any genuine guidance. State- ments such as “little or no risk,” “maximize return,” or “preserve capital” are virtually useless to a portfolio manager unless they are clearly defined and explained.

A written investment policy statement enables you to discover your client’s long-term goals and objectives—plus, it will serve as a guideline for implementing the investment strategy. The written policy statement helps you maintain a sound long-term plan, when short-term market movements cause you to second-guess the actions you have previously taken.

All separate account investors should have an investment policy statement that outlines their goals and how their money will be invested to reach those

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goals. Here’s why: People are human and can get caught up in the emotion of the day. It is only through long-term planning that your clients are going to be successful and not fall back into old habits. In the heat of a market downturn, it is critical to have thought out strategy ahead of time and to have it docu- mented so that they will not deviate from its path.

Creating an investment policy statement embodies the essence of the financial planning process: assessing where you are now, where you want to go, and developing a strategy to get there. Having and using this policy statement compels you to become more disciplined and systematic, increasing the probability that your actions will be appropriate in times of economic or market distress, while also satisfying your investment goals.

There are six steps to establishing an investment policy:

1. Set long-term goals and objectives clearly and concisely. Long-term goals can be anything from early retirement to purchasing a new home. One of the most common goals we have found among our clients is to be finan- cially independent. What that often means to our clients is that their investment portfolio will provide them with the income necessary to maintain their quality of life and that it will continue to increase at a pace greater than the cost of living.

2. Define the level of risk your clients are willing to accept. Along the road to reaching financial goals, there are going to be bumps caused by the downturn in various market cycles. It is important that your clients understand the amount of risk they’re willing to tolerate during the investment period. In designing a portfolio, it must be determined what the absolute loss your client is willing to accept in any one-year period is without terminating his/her investment program. As we know, no one can predict market movements, and your clients have to be in a position to weather any storm.

One way to determine the level of risk in a portfolio is to look at its performance during 1973 and 1974. Investors should be honest with themselves.

No one can predict the future. The years 2000–2002 might be similar to 1973 and 1974. It was during these years that we experienced the worst financial recession since World War II. There is a 5 percent probability that in the next 20 years we will experience a similar downturn. You probably remember waiting in line for gas. The Standard & Poor’s 500 (S&P 500) lost 37.2 percent and small-company stocks lost 56.5 percent. Most investors would have a hard time maintaining a long-term perspective and staying with their investment program in markets like this.

If an investor is working with a financial advisor, he/she can request an 126 THE PROCESS

analysis of how the portfolio mix would have performed during 1973 and 1974. The portfolio mix with which the investor would have been comfortable should be selected. If the account would have been closed because of that downturn, there was too much risk and a lower-risk model portfolio should be constructed. Investments tend to be cyclical, and no one can predict their performance in the short term. The best-performing year for both the S&P 500 and small-company stocks was 1975, when they earned 37.2 and 65.7 percent, respectively, which interestingly was right after the bear market of 1973 and 1974.

A more recent reference point is the bear market of 2000 through 2002, which, as of this writing, is continuing. This market has resulted in the Nasdaq index dropping more than 75 percent from its all-time high! And, the result could be that, for the first time in more than 50 years, the major market aver- ages will end up down three years in a row. Consider the performance of various portfolios, various managers, various investment styles in this type of market and then determine with what portfolio structure your client is most comfortable.

3. Establish the expected time horizon. Investors have to determine the investment period in which their capital will be working for them to achieve the designated financial objective. For the equity portion of their portfolio, the minimum expected investment period should be at least five years. For any portfolio with less than a five-year time horizon, the portfolio should con- sist predominantly of fixed investments. This five-year minimum investment period is critical in analyzing and determining the level of risk the investor is willing to assume. For all investment endeavors, the investment process must be viewed as a long-term plan for achieving the desired results. One-year volatility can be significant for many equity asset classes but this surely is not representative of a long-term investment process as embodied in an investment policy statement. However, over a five-year period, the variability of returns is greatly reduced with more predictable results and identified risk parameters.

As the chart in Figure 10.1 indicates, if you’re planning to invest for a life- time, the range of returns of a diversified model portfolio (encompassing only equities) becomes minimal.

4. Determine the rate-of-return objective. Even sophisticated investors tend to focus on their rate-of-return objectives rather than risk. The rate of return is going to be a direct result of the willingness to take risk and the length of time the assets are invested. In getting started, your clients should write down a range of returns that would be acceptable.

The Creative Process of Writing an Investment Policy Statement 127

You should then conduct a study of modern portfolio theory investment results to determine what the optimal portfolio should look like given the amount of risk your clients are willing to assume. In this way, you will be focusing on actual historical results to determine the various asset class weightings that have the greatest potential of meeting their rate-of-return objective while maintaining the risk profile they are willing to assume.

5. Select the asset classes to be used to build the core portfolio. List all the different asset classes that you might want to consider in the portfolio.

You may be surprised with the differences between what you’ve been using in the past and what you should be using. Once you’ve identified them, you need to determine how you’re going to allocate capital to each asset class and what asset classes will represent the core portion of the portfolio (Table 10.1).

6. Document the investment methodology to be used in managing your portfolio. As we discussed in Chapter 3, there are three basic investment methodologies: (1) security selection, (2) market timing, and (3) core investing. The only proven methodology for the prudent investor is to use core investing strategies that, when implemented, result in a properly diversified portfolio with understandable levels of risk.

However, admittedly there are many investment methodologies to achieve the same objective. Some of these would include lump-sum investing, periodic investing over specified time frames, market weighting allocations, as well as style-specific versus a blended approach. Regardless of which 128 THE PROCESS

29.9 %

19.5%

16.8% 16.2 %

12.3% 13.4% 14.3%

-8.1%

6.1%

10.2%

13.0 % 14.2 %13.0 % 12.6 % 12.0 %

-10 -5

0.0 % 5.0 % 10.0 % 15.0 % 20.0 % 25.0 % 30.0 %

High Average Low

1 Year

5 Years

10 Years

15 Years

20 Years .0 %

.0 %

FIGURE10.1 Conservative Model Returns, 1972 to 1993.

The Creative Process of Writing an Investment Policy Statement 129

TABLE10.1 Risk/Return Comparisons Level of Target

Decline Growth Rate Approximate

(%) (%) Time Frame Core Strategy Riskometer

3 3–5 0–6 months CDs, money

markets Bond fund,

6 5–6 3–12 months money markets,

CDs, cash Conservative

8 6–8 6 months– balanced

2 years portfolio, bonds:

Portfolio 1

10 8–9 18 months– Balanced fund:

3 years Portfolio 2

15 9–11 3–5 years Conservative

equity:

Portfolio 3

23 10–13 5–7 years Equity fund:

Portfolio 4

35 11–14 5–10 years Equities:

Portfolio 4 Equities:

50 12–15 5–10 years Portfolio 4

Action:Write down a range of returns that would be acceptable. You can use this range of returns for each risk level as the framework to determine the return expectation for the portfolio, as well as for the component asset classes.

Target growth rate:

Make sure the target growth rate aligns with the time horizon.

Notes:Find the target rate-of-return percentage; be aware of the level of decline that may be experienced, and then look at the Riskometer to see what the level of risk is.

2 3

4 5