Dedicated Portfolio Theory
Encyclopedia
Dedicated Portfolio Theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds
and/or other fixed income securities (such as Certificates of Deposit
) that can and usually are held to maturity
to generate this predictable stream from the coupon
interest and/or the repayment of the face value
of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing (and dollars) of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching
, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.
, was the first to refer to dedicated portfolios as “cash matching” portfolios. He demonstrated how they are the simplest case of the technique known as bond portfolio immunization. In his sketch of its history, he traces the origin of immunization to Frederick R. Macaulay
who first suggested the notion of “duration” for fixed income securities in 1938. Duration represents the average life of the coupon payments and redemption of a bond and links changes in interest rates to the volatility of a bond’s value. One year later, J.R. Hicks
independently developed a similar formulation referred to as the “average period.” In 1942, T.C. Koopmans
pointed out in a report that, by matching the duration of the bonds held in a portfolio to the duration of liabilities those bonds would fund, the effects of interest rate changes could be mitigated or nullified completely, i.e. immunized. In 1945, Paul Samuelson
formulated essentially the same concept, calling it the “weighted-average time period.” None of these earliest researchers cited each other’s work, suggesting each developed the concept independently. The work culminated in a 1952 paper by a non-academic actuary, F. M. Redington
, who worked for a British insurance company.
This body of work was largely ignored until 1971, when Lawrence Fisher and Roman Weil
re-introduced immunization to the academic community in a journal article that followed a 1969 report written for the Center for Research in Securities Prices
. Shortly thereafter, in 1972, I.T. Vanderhoof presented the concept to the American actuarial community. Academic papers on immunization, duration, and dedication began to appear in increasing numbers, as interest rates began to rise. As rates rose further and further above their long term averages, the financial investment industry began to pay attention, and their inquiries increasingly attracted the attention of academic researchers. Realizing that the high rates would allow them to lock in unprecedented rates of return, defined-benefit pension fund managers embraced the concepts. Goldman Sachs
and other high level firms began to produce software to help bond portfolio managers apply the theory to their institutional sized portfolios. Most of the examples used in the literature typically utilized portfolios consisting of several hundred million dollars. In 1981, Leibowitz and Weinberger published a report on “contingent immunization” discussing the blending of active management of bond portfolios with immunization to provide a floor on returns. Leibowitz also published a paper in two parts defining dedicated portfolios in 1986. One of the side benefits of the theoretical work and practical interest was the development of new fixed income instruments, such as zero-coupon bonds. The most recent book on the topic by Huxley and Burns, based on a research project at the University of San Francisco was published in the late 1990's and a book titled Asset Dedication was published in 2005 described how the advances in desktop computers reduced the cost of constructing dedicated portfolios to levels where individual investors could use the concept for personal investing, such as the example below shows for a retirement portfolio.
will supply some income, but the rest will have to come from their portfolio
. They have accumulated a retirement portfolio worth $2,000,000. Typically, retirement portfolios have a higher percentage of bonds in their portfolio than portfolios owned by younger people who are not yet approaching retirement. Probably the most common retirement portfolio would be a 60/40 stock/bond allocation compared to an 80/20 or 90/10 stock/bond allocation for younger investors. Following a common rule of thumb for retirement withdrawal rates to make a retirement portfolio last at least 30 years, they should withdraw no more than 5 percent
from their portfolio the first year ($100,000). They can increase it each year by the amount of the previous year’s inflation. To be conservative, they will plan for an annual inflation
rate of 3 percent (they may not spend it, but want the protection just in case). Table 1,The 10-year Treasury rose above its long term average in 1968, more than one standard deviation above in 1975, and more than two standard deviations above in 1980, and more than three standard deviations in 1981. lists the projected stream of withdrawals. These withdrawals represent the yearly “income” the couple requires to pay living expenses over their first eight years of retirement. Note that the total cash flow needed over the entire eight years sums to $889,234.
Table 2 shows series of bonds and CDs
with staggered maturities whose coupon and principal payments will match the stream of income shown in the Target Cash Flows column in Table 1 (rates are fictitious for this example). The cash flow generated by the portfolio for the first year would be $100,380. This consists of the principal of the bond maturing on 2/15/2012 plus the coupon interest payments flowing from all the other bonds. The same would be true for the next year and every year thereafter. The total cash flows generated over the eight years sum to $889,350, compared to the target cash flow sum of $889,234, a difference of only $116. As with the first year, the cash flows are very close to the target cash flows needed for each year. The match cannot be perfect because bonds must usually be purchased in denominations of $1,000 (municipal bonds in denominations of $5,000). However, with the use of fairly sophisticated mathematical optimization techniques
, correlations of 99 percent or better can usually be obtained.These techniques also determine which bonds to buy so as to minimize the cost of meeting the cash flows, which in this example is $747,325. Note that in this example, the bonds all mature on February 15, the middle of the first quarter. Other dates may be used, of course, such as the anniversary date of the portfolio’s implementation.
This would be the initial dedicated portfolio for the couple. But they hopefully have a lifetime financial plan designed to last 30 or 40 years. Over time, that means the portfolio will need to be updated or rolled forward as each year passes to maintain the same 8-year time horizon. The time horizon could be extended by adding another bond with an 8-year maturity or the equivalent. Extending on a regular basis could therefore provide a perpetual series of 8-year horizons of protected income over the investor’s entire lifetime and become the equivalent of a self-annuity
.
Note that the fixed income securities shown in the example are high quality, safe “investment grade” fixed income securities, CDs and government-sponsored agency bonds, all chosen to avoid the risk of default
. United States Treasury bonds, considered to be the safest investments on earth, could also be used. But they have lower yields, meaning a portfolio of Treasuries to meet the same flows would cost more than CDs and agencies. Triple-A rated corporate bonds are another option and usually have higher yields, but are theoretically riskier than government-sponsored bonds. Also, triple-A rated corporate bonds have become scarce since the financial crisis of 2008 over the wide range of maturities needed for dedicated portfolios. Investors willing to take greater risks may use any quality of bond deemed acceptable in light of their higher yields, though safety would likely be of paramount importance for retirement.
Recall that a secondary goal of dedicated portfolio theory is to select the bonds that will provide the requisite cash flows at the lowest possible cost, given requirements on the minimum quality of bonds to be considered (thus the need for calculation). In this fictitious example, the cost shown is $747,325 to purchase this initial set of bonds, excluding transaction costs and fees, but the actual cost would vary depending on yields, quality of bonds used, and length of the time horizon. It would also depend on the starting time for the cash flows. If this couple planned to retire in five years, they could defer the starting time to coincide with their retirement date, and buy bonds maturing in 2016–2023. Yields would likely be higher on these bonds because they are further out on the yield curve
.
Note that any of the bonds could be zero coupon bonds, meaning they do not pay any coupon interest. It would be easy to build a dedicated portfolio consisting entirely of zero coupon bonds, but their yields can often be lower than coupon bonds. Another problem with “zeros” is that taxes must be paid each year on the increase in value of a zero-coupon bond (assuming it is held in a taxable account), even though no interest was actually received.
Returning to our example, assume that this “income portfolio” were actually purchased, and the balance of the funds were invested in a “growth portfolio” of equity mutual funds or similar types of faster growing investments. The initial asset allocation would become 37% bonds, 63% stocks (see Table 3).
s cannot provide this certainty because they hold large volumes of many different bonds and typically trade them rather than holding them to maturity. Thus, they behave more like sluggish stock funds in terms of volatility
.
2. Avoidance or reduction of investment risks. A number of risks associated with owning bonds are avoided or mitigated by using a dedicated portfolio:
3. Specificity. Because dedicated portfolios are designed to provide a specific stream of funds to match future target cash flows, those cash flows must be quite specific in terms of timing and amounts. This need for specificity forces anyone contemplating a dedicated portfolio investment strategy to put careful thought into developing a formal, lifetime financial plan, as opposed to merely relying on vague or hazy goals and hoping for the best. The resulting asset allocation is based explicitly on the plan, instead of a generic model portfolio. This, of course, is the essence of serious financial planning, and the result is a portfolio that is tailored to the specific needs of each investor.
4. Asset Allocation. One of the shortcomings of Modern Portfolio Theory
is that it provides only a general notion of how assets should be allocated among the major asset classes (stocks, bonds, and cash). It focuses on the tradeoff between return and volatility – that is, higher returns can be earned only by investments that fluctuate more rapidly and with greater intensity. Dedicated portfolio theory focuses explicitly on cash flows and time horizons. If done properly, it allocates to fixed income no more than the minimum funds necessary to generate the desired cash flows, and all other funds can be invested elsewhere, as demonstrated in the example above. Most investors find this to be a more intuitive explanation for why their assets are allocated the way they are.
5. Passive Management. There are two primary modes of thought on portfolio management. Advocates of active management
believe that better returns are achieved by trying to time the market and selecting hot stocks (in other words, trying to predict the future). Advocates of passive management
believe that better returns are achieved by buying broad based mutual fund
s, such as index fund
s, and holding them. Most academic research suggests that passive management has, in fact, historically produced higher returns over the long run. Dedicated portfolios fall into the category of passive management because once bonds are purchased, they are held to maturity. If all remaining funds are invested in an index fund, then the entire portfolio could be regarded as 100 percent passive. (Index fund providers, such as Dimensional Fund Advisors
and Vanguard can supply voluminous research results on the active/passive management debate.)
1. The primary disadvantage of dedicated portfolios is that they are not easy to construct. They require expertise in bonds and other fixed income securities. Not all bonds are suitable for dedicated portfolios. For instance, they cannot use callable bonds because a called bond will create an unpredicted cash inflow that will require reintegration with the stream of undisturbed cash flows.
2. They require a high level of expertise in the mathematics of optimization theory
. To determine the right quantities for each maturity to match the cash flows at minimum cost requires a technique known as mathematical programming.
3. They require formal financial planning
and specificity to develop the target cash flows for each year and determine an appropriate time horizon, which, in turn, require time, thought, and effort on the part of both the investor and the financial advisor.
4. They require that the inventory of bonds available is sufficient to provide maturities at the right dates, in the right quantities, and of the right qualities to fit the portfolio desired. One reason bond funds are more popular than individual bonds with some advisors is that bond funds make it very easy and convenient for the advisor to buy a fixed income allocation with the click of a button. Because of their complexity, dedicated portfolios often require the use of outside consultants or money managers with separately managed account
s who may charge more or less than the fees charged by bond funds, and advisors must weigh the relative costs and benefits.
5. Dedicated portfolios require even more sophisticated management when considered from a dynamic standpoint. As time passes, the time horizon of protected cash flows will become progressively shorter. What started as an 8-year span becomes a 7-year span at the end of the first year. As each year passes, the decision must be made whether to roll the portfolio forward to maintain a perpetual 8-year horizon. Extending the portfolio out another year (after the initial year) would require buying a new 8- year bond and making the required adjustments to manage its cash flows. Thus, ongoing management is required for dedicated portfolios (as it is for all investing activities).
Notes
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
and/or other fixed income securities (such as Certificates of Deposit
Certificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
) that can and usually are held to maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
to generate this predictable stream from the coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
interest and/or the repayment of the face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing (and dollars) of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching
Cashflow matching
Cashflow matching is a process of hedging in which a company or other entity matches its cash outflows with its cash inflows.-See also:*Cash-flow hedging*Duration gap*Dedicated Portfolio Theory*Fannie Mae-External links:**...
, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.
History
The most prolific author on dedicated portfolio theory, Martin L. LeibowitzMartin L. Liebowitz
Martin L. Leibowitz is a well-known financial researcher and business leader. Since 2004 he has been a Managing Director of Morgan Stanley. Prior to joining Morgan Stanley, he was vice chairman and chief investment officer of TIAA-CREF from 1995 to 2004, and before that he was employed for 26 years...
, was the first to refer to dedicated portfolios as “cash matching” portfolios. He demonstrated how they are the simplest case of the technique known as bond portfolio immunization. In his sketch of its history, he traces the origin of immunization to Frederick R. Macaulay
Frederick Macaulay
Frederick Robertson Macaulay was an economist of the Institutionalist School. He is known for introducing the concept of bond duration...
who first suggested the notion of “duration” for fixed income securities in 1938. Duration represents the average life of the coupon payments and redemption of a bond and links changes in interest rates to the volatility of a bond’s value. One year later, J.R. Hicks
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...
independently developed a similar formulation referred to as the “average period.” In 1942, T.C. Koopmans
Tjalling Koopmans
Tjalling Charles Koopmans was the joint winner, with Leonid Kantorovich, of the 1975 Nobel Memorial Prize in Economic Sciences....
pointed out in a report that, by matching the duration of the bonds held in a portfolio to the duration of liabilities those bonds would fund, the effects of interest rate changes could be mitigated or nullified completely, i.e. immunized. In 1945, Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
formulated essentially the same concept, calling it the “weighted-average time period.” None of these earliest researchers cited each other’s work, suggesting each developed the concept independently. The work culminated in a 1952 paper by a non-academic actuary, F. M. Redington
Frank Redington
Frank Mitchell Redington was a noted British actuary. Frank Redington was best known for his development of Immunisation Theory which specifies how a fixed income portfolio can be "immunised" against changing interest rates....
, who worked for a British insurance company.
This body of work was largely ignored until 1971, when Lawrence Fisher and Roman Weil
Center for Research in Securities Prices
The Center for Research in Security Prices is a provider of historical stock market data. The Center is a part of the Booth School of Business at the University of Chicago. CRSP maintains some of the largest and most comprehensive proprietary historical databases in stock market research...
re-introduced immunization to the academic community in a journal article that followed a 1969 report written for the Center for Research in Securities Prices
Center for Research in Securities Prices
The Center for Research in Security Prices is a provider of historical stock market data. The Center is a part of the Booth School of Business at the University of Chicago. CRSP maintains some of the largest and most comprehensive proprietary historical databases in stock market research...
. Shortly thereafter, in 1972, I.T. Vanderhoof presented the concept to the American actuarial community. Academic papers on immunization, duration, and dedication began to appear in increasing numbers, as interest rates began to rise. As rates rose further and further above their long term averages, the financial investment industry began to pay attention, and their inquiries increasingly attracted the attention of academic researchers. Realizing that the high rates would allow them to lock in unprecedented rates of return, defined-benefit pension fund managers embraced the concepts. Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
and other high level firms began to produce software to help bond portfolio managers apply the theory to their institutional sized portfolios. Most of the examples used in the literature typically utilized portfolios consisting of several hundred million dollars. In 1981, Leibowitz and Weinberger published a report on “contingent immunization” discussing the blending of active management of bond portfolios with immunization to provide a floor on returns. Leibowitz also published a paper in two parts defining dedicated portfolios in 1986. One of the side benefits of the theoretical work and practical interest was the development of new fixed income instruments, such as zero-coupon bonds. The most recent book on the topic by Huxley and Burns, based on a research project at the University of San Francisco was published in the late 1990's and a book titled Asset Dedication was published in 2005 described how the advances in desktop computers reduced the cost of constructing dedicated portfolios to levels where individual investors could use the concept for personal investing, such as the example below shows for a retirement portfolio.
Example of a Dedicated Portfolio
While most of the original work on dedicated portfolios was done for large institutional investors such as pension funds, the most recent applications have been to personal investing. This example is a couple who wants to retire in 2011 and has already set aside cash to cover their expenses for that year. Social securitySocial Security (United States)
In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...
will supply some income, but the rest will have to come from their portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
. They have accumulated a retirement portfolio worth $2,000,000. Typically, retirement portfolios have a higher percentage of bonds in their portfolio than portfolios owned by younger people who are not yet approaching retirement. Probably the most common retirement portfolio would be a 60/40 stock/bond allocation compared to an 80/20 or 90/10 stock/bond allocation for younger investors. Following a common rule of thumb for retirement withdrawal rates to make a retirement portfolio last at least 30 years, they should withdraw no more than 5 percent
Trinity study
In finance, investment advising, and retirement planning, the Trinity study is an informal name used to refer to an influential 1998 paper by three professors of finance at Trinity University...
from their portfolio the first year ($100,000). They can increase it each year by the amount of the previous year’s inflation. To be conservative, they will plan for an annual inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
rate of 3 percent (they may not spend it, but want the protection just in case). Table 1,The 10-year Treasury rose above its long term average in 1968, more than one standard deviation above in 1975, and more than two standard deviations above in 1980, and more than three standard deviations in 1981. lists the projected stream of withdrawals. These withdrawals represent the yearly “income” the couple requires to pay living expenses over their first eight years of retirement. Note that the total cash flow needed over the entire eight years sums to $889,234.
Table 2 shows series of bonds and CDs
Certificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
with staggered maturities whose coupon and principal payments will match the stream of income shown in the Target Cash Flows column in Table 1 (rates are fictitious for this example). The cash flow generated by the portfolio for the first year would be $100,380. This consists of the principal of the bond maturing on 2/15/2012 plus the coupon interest payments flowing from all the other bonds. The same would be true for the next year and every year thereafter. The total cash flows generated over the eight years sum to $889,350, compared to the target cash flow sum of $889,234, a difference of only $116. As with the first year, the cash flows are very close to the target cash flows needed for each year. The match cannot be perfect because bonds must usually be purchased in denominations of $1,000 (municipal bonds in denominations of $5,000). However, with the use of fairly sophisticated mathematical optimization techniques
Optimization (mathematics)
In mathematics, computational science, or management science, mathematical optimization refers to the selection of a best element from some set of available alternatives....
, correlations of 99 percent or better can usually be obtained.These techniques also determine which bonds to buy so as to minimize the cost of meeting the cash flows, which in this example is $747,325. Note that in this example, the bonds all mature on February 15, the middle of the first quarter. Other dates may be used, of course, such as the anniversary date of the portfolio’s implementation.
This would be the initial dedicated portfolio for the couple. But they hopefully have a lifetime financial plan designed to last 30 or 40 years. Over time, that means the portfolio will need to be updated or rolled forward as each year passes to maintain the same 8-year time horizon. The time horizon could be extended by adding another bond with an 8-year maturity or the equivalent. Extending on a regular basis could therefore provide a perpetual series of 8-year horizons of protected income over the investor’s entire lifetime and become the equivalent of a self-annuity
Annuity (finance theory)
The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money...
.
Note that the fixed income securities shown in the example are high quality, safe “investment grade” fixed income securities, CDs and government-sponsored agency bonds, all chosen to avoid the risk of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. United States Treasury bonds, considered to be the safest investments on earth, could also be used. But they have lower yields, meaning a portfolio of Treasuries to meet the same flows would cost more than CDs and agencies. Triple-A rated corporate bonds are another option and usually have higher yields, but are theoretically riskier than government-sponsored bonds. Also, triple-A rated corporate bonds have become scarce since the financial crisis of 2008 over the wide range of maturities needed for dedicated portfolios. Investors willing to take greater risks may use any quality of bond deemed acceptable in light of their higher yields, though safety would likely be of paramount importance for retirement.
Recall that a secondary goal of dedicated portfolio theory is to select the bonds that will provide the requisite cash flows at the lowest possible cost, given requirements on the minimum quality of bonds to be considered (thus the need for calculation). In this fictitious example, the cost shown is $747,325 to purchase this initial set of bonds, excluding transaction costs and fees, but the actual cost would vary depending on yields, quality of bonds used, and length of the time horizon. It would also depend on the starting time for the cash flows. If this couple planned to retire in five years, they could defer the starting time to coincide with their retirement date, and buy bonds maturing in 2016–2023. Yields would likely be higher on these bonds because they are further out on the yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
.
Note that any of the bonds could be zero coupon bonds, meaning they do not pay any coupon interest. It would be easy to build a dedicated portfolio consisting entirely of zero coupon bonds, but their yields can often be lower than coupon bonds. Another problem with “zeros” is that taxes must be paid each year on the increase in value of a zero-coupon bond (assuming it is held in a taxable account), even though no interest was actually received.
Returning to our example, assume that this “income portfolio” were actually purchased, and the balance of the funds were invested in a “growth portfolio” of equity mutual funds or similar types of faster growing investments. The initial asset allocation would become 37% bonds, 63% stocks (see Table 3).
Advantages
1. Predictable cash flows. Because the dates and amounts of the coupon and redemption payments are known in advance, individual bonds held to maturity offer something few other financial investments can provide: predictability. Most bond fundBond fund
A bond fund is a collective investment scheme that invests in bonds and other debt securities. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than...
s cannot provide this certainty because they hold large volumes of many different bonds and typically trade them rather than holding them to maturity. Thus, they behave more like sluggish stock funds in terms of volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
.
2. Avoidance or reduction of investment risks. A number of risks associated with owning bonds are avoided or mitigated by using a dedicated portfolio:
- a.Market riskMarket riskMarket risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
(or capital risk) is avoided because the bonds are held to maturity. The market price at which the bond could be sold at any point in time may rise or fall before it reaches maturity, but these fluctuations are irrelevant to the investor if the bonds are held until they are paid off at face value. Of course, an investor does have the flexibility to sell off the bonds at any time in case an emergency arises.
- b.Reinvestment riskReinvestment riskReinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available...
is avoided because the interest and principal from the bonds are spent to fund the liabilities (such as the living expenses for the retiree) rather than being reinvested.
- c.Inflation riskGovernment bondA government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
is mitigated by building an anticipated inflation adjustment into the target cash flows – recall the 3 percent annual adjustment used in the example. If inflation averages more than 3 percent, then the investor’s real incomeReal incomeReal income is the income of individuals or nations after adjusting for inflation. It is calculated by subtracting inflation from the nominal income...
will fall; that is, it will not be sufficient to provide the same standard of living. This inflation risk can be avoided entirely if inflation indexed bondsInflation-indexed bondInflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...
such as TIPS are used to build the dedicated portfolio. These bonds pay coupon interest plus increase the principal by the rate of inflation from the previous year, then pay coupon interest on the inflated amount the next year. At redemption, they pay the full face value, plus the accumulated inflation.
- d.Default risk (or credit risk) is mitigated by using only high quality investment grade bonds similar to those shown in the example above. Investors who are willing to assume more risk can build dedicated portfolios with lower quality bonds, gambling that a sufficient number of them will pay off ultimately.
- e.Liquidity riskLiquidity riskIn finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
is mitigated because individual bonds can be sold if the need arises. This is a significant advantage compared to annuities, which are not tradable securities.
3. Specificity. Because dedicated portfolios are designed to provide a specific stream of funds to match future target cash flows, those cash flows must be quite specific in terms of timing and amounts. This need for specificity forces anyone contemplating a dedicated portfolio investment strategy to put careful thought into developing a formal, lifetime financial plan, as opposed to merely relying on vague or hazy goals and hoping for the best. The resulting asset allocation is based explicitly on the plan, instead of a generic model portfolio. This, of course, is the essence of serious financial planning, and the result is a portfolio that is tailored to the specific needs of each investor.
4. Asset Allocation. One of the shortcomings of Modern Portfolio Theory
Modern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
is that it provides only a general notion of how assets should be allocated among the major asset classes (stocks, bonds, and cash). It focuses on the tradeoff between return and volatility – that is, higher returns can be earned only by investments that fluctuate more rapidly and with greater intensity. Dedicated portfolio theory focuses explicitly on cash flows and time horizons. If done properly, it allocates to fixed income no more than the minimum funds necessary to generate the desired cash flows, and all other funds can be invested elsewhere, as demonstrated in the example above. Most investors find this to be a more intuitive explanation for why their assets are allocated the way they are.
5. Passive Management. There are two primary modes of thought on portfolio management. Advocates of active management
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
believe that better returns are achieved by trying to time the market and selecting hot stocks (in other words, trying to predict the future). Advocates of passive management
Passive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
believe that better returns are achieved by buying broad based mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s, such as index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s, and holding them. Most academic research suggests that passive management has, in fact, historically produced higher returns over the long run. Dedicated portfolios fall into the category of passive management because once bonds are purchased, they are held to maturity. If all remaining funds are invested in an index fund, then the entire portfolio could be regarded as 100 percent passive. (Index fund providers, such as Dimensional Fund Advisors
Dimensional Fund Advisors
Dimensional Fund Advisors is an investment firm headquartered in Austin, Texas with regional offices in Amsterdam, Berlin, London, Santa Monica, Sydney, and Vancouver. The company was founded in 1981 by David G. Booth and Rex Sinquefield, both graduates of the University of Chicago Booth School of...
and Vanguard can supply voluminous research results on the active/passive management debate.)
Disadvantages
Dedicated portfolios are not without disadvantages:1. The primary disadvantage of dedicated portfolios is that they are not easy to construct. They require expertise in bonds and other fixed income securities. Not all bonds are suitable for dedicated portfolios. For instance, they cannot use callable bonds because a called bond will create an unpredicted cash inflow that will require reintegration with the stream of undisturbed cash flows.
2. They require a high level of expertise in the mathematics of optimization theory
Optimization (mathematics)
In mathematics, computational science, or management science, mathematical optimization refers to the selection of a best element from some set of available alternatives....
. To determine the right quantities for each maturity to match the cash flows at minimum cost requires a technique known as mathematical programming.
3. They require formal financial planning
Financial planner
A financial planner or personal financial planner is a practicing professional who helps people deal with various personal financial issues through proper planning, which includes: cash flow management, education planning, retirement planning, investment planning, risk management and insurance...
and specificity to develop the target cash flows for each year and determine an appropriate time horizon, which, in turn, require time, thought, and effort on the part of both the investor and the financial advisor.
4. They require that the inventory of bonds available is sufficient to provide maturities at the right dates, in the right quantities, and of the right qualities to fit the portfolio desired. One reason bond funds are more popular than individual bonds with some advisors is that bond funds make it very easy and convenient for the advisor to buy a fixed income allocation with the click of a button. Because of their complexity, dedicated portfolios often require the use of outside consultants or money managers with separately managed account
Separately managed account
A separately managed account is an individual managed investment account offered typically by a brokerage firm through one of their brokers or financial consultants and managed by independent investment management firms and have varying fee structures...
s who may charge more or less than the fees charged by bond funds, and advisors must weigh the relative costs and benefits.
5. Dedicated portfolios require even more sophisticated management when considered from a dynamic standpoint. As time passes, the time horizon of protected cash flows will become progressively shorter. What started as an 8-year span becomes a 7-year span at the end of the first year. As each year passes, the decision must be made whether to roll the portfolio forward to maintain a perpetual 8-year horizon. Extending the portfolio out another year (after the initial year) would require buying a new 8- year bond and making the required adjustments to manage its cash flows. Thus, ongoing management is required for dedicated portfolios (as it is for all investing activities).
Notes
External links
- http://www.assetdedication.com/ Asset Dedication - Portfolio engineering firm that builds dedicated portfolios. Includes a link (“Advisorspace”) that builds dedicated portfolios for simple cases based on inputs.
- http://www.dfaus.com/ Dimensional Fund Advisors website; DFA specializes in index funds and passive management. Its founders did the original research that led to the style box now used to classify funds based on size and value/growth.
- http://www.financial-planning.com/fp_issues/2008_2/match-makers533561-1.html Financial Planning Magazine - Article on dedicated portfolios for retirees.
- http://www.investopedia.com/terms/d/dedicatedportfolio.asp Investopedia - Definition of dedicated portfolios
- http://www.vanguard.com/ Vanguard - Vanguard’s official website; John Bogle was among the first to start index investing for the general public and Vanguard was the largest mutual fund provider in the world in 2009.