Archive for October, 2009

Selecting a portfolio strategy that is consistent with the investment objectives and investment policy guidelines of the client or institution is the third step in the investment management process. Portfolio strategies can be classified as either active or passive.
An active portfolio strategy uses available information and forecast- ing techniques to seek a better performance than a portfolio that is sim- ply diversified broadly. Essential to all active strategies are expectations about the factors that have been found to influence the performance of an asset class. For example, with active common stock strategies this may include forecasts of future earnings, dividends, or price-earnings ratios. With bond portfolios that are actively managed, expectations may involve forecasts of future interest rates and sector spreads. Active portfolio strategies involving foreign securities may require forecasts of local interest rates and exchange rates.
A passive portfolio strategy involves minimal expectational input, and instead relies on diversification to match the performance of some market index. In effect, a passive strategy assumes that the marketplace will reflect all available information in the price paid for securities. Between these extremes of active and passive strategies, several strategies have sprung up that have elements of both. For example, the core of a portfolio may be passively managed with the balance actively managed.
In the bond area, several strategies classified as structured portfolio strategies have been commonly used. A structured portfolio strategy is one in which a portfolio is designed to achieve the performance of some predetermined liabilities that must be paid out. These strategies are frequently used when trying to match the funds received from an investment portfolio to the future liabilities that must be paid.
Given the choice among active and passive management, which should be selected? The answer depends on (1) the client’s or money manager’s view of how “price-efficient” the market is, (2) the client’s risk tolerance, and (3) the nature of the client’s liabilities. By market- place price efficiency we mean how difficult it would be to earn a greater return than passive management after adjusting for the risk associated with a strategy and the transaction costs associated with implementing that strategy.

Tax considerations are important for several reasons. First, in the United States, certain institutional investors such as pen- sion funds, endowments, and foundations are exempt from federal income taxation. Consequently, the assets in which they invest will not be those that are tax-advantaged investments. Second, there are tax factors that must be incorporated into the investment policy. For example, while a pension fund might be tax-exempt, there may be certain assets or the use of some investment vehicles in which it invests whose earnings may be taxed.
Generally accepted accounting principles (GAAP) and regulatory accounting principles (RAP) are important considerations in developing investment policies. An excellent example is a defined benefit plan for a corporation. GAAP specifies that a corporate pension fund’s surplus is equal to the difference between the market value of the assets and the present value of the liabilities. If the surplus is negative, the corporate sponsor must record the negative balance as a liability on its balance sheet. Consequently, in establishing its investment policies, recognition must be given to the volatility of the market value of the fund’s portfolio relative to the volatility of the present value of the liabilities.

There    are    many    types    of    regulatory    constraints. These involve constraints on the asset classes that are permissible and concentration limits on investments. Moreover, in making the asset allcation decision, consideration must be given to any risk-based capital requirements. For depository institutions and insurance companies, the amount of statutory capital required is related to the quality of the assets in which the institution has invested. There are two types of risk- based capital requirements: credit risk-based capital requirements and interest rate-risk based capital requirements. The former relates statutory capital requirements to the credit-risk associated with the assets in the portfolio. The greater the credit risk, the greater the statutory capital required. Interest rate-risk based capital requirements relate the statutory capital to how sensitive the asset or portfolio is to changes in interest rates. The greater the sensitivity, the higher the statutory capital required.