Institutional investors have used dedicated portfolio strategies like pension funds and insurance companies for many years, and these strategies have gained popularity with individual investors looking to manage risk.
The basic concept of portfolio dedication is to design investment portfolios that deliver predictable future cash flows to approximate future predictable cash outflows (or liabilities), thus mitigating the risk during that period. This can be accomplished with a few variations like direct matching or immunizing cash flows with horizon matching portfolios. These set minimum thresholds of payouts with room for discretional moves and contingent strategies that also meet basic cash flow matching with some ability to add value. The concept design is simplistic and should be used in conjunction with long-term asset allocation using empirical data to estimate future asset levels and cash flows. Portfolio dedication strategies can be accomplished with traditional investments or with derivatives like futures, forwards and options. While individual investors are using dedication more and more, it’s very easy to fall back to using primarily asset allocation planning, especially when markets are doing well, volatility is low and complacency sets in.
Immunization is one of the purest forms of dedicated investing, as it directly locks in future cash flow needs with the predictable future value of an investment like a CD or zero coupon bond or bullet. This is a popular strategy, especially for pension funds, because the exact dates for future payouts to plan participants are already known. While the plan sponsor can’t predict exactly when a plan member will pass away (asset allocation and actuarial tables are better suited here), the sponsor does know when fixed defined benefit payments will be made to plan participants. This works especially well on 3-5 year liability matching as zero coupon bonds mitigate interest and reinvestment risk, basically locking in the future payment.
For individual investors, knowing you will need $30,000 in one year for your child's tuition or $40,000 to replace an aging car in two years are good examples of future liabilities for which to build a dedicated portfolio.
Duration is a useful tool in dedicated portfolio strategies on small and large scales, since it can be calculated for both liabilities and fixed-income assets. For a bond, duration measures the sensitivity of the price to a change in interest rates. Duration in its purest form is a zero-coupon bond as its maturity matches its duration, as there are no periodic cash flows to shorten its time horizon. For an interest-bearing bond, its duration will be shorter than its maturity as the incoming coupons shorten the time it takes an investor to receive invested capital. Duration is a relatively accurate way to measure a bond’s risk level. For example, a 10-year interest-bearing bond may have a duration of around 7. A good rule of thumb implies that for every 1% increase in interest rates, this bond should decrease in value by around 7%.
Liabilities, or future cash outflow needs, also have similar characteristics of duration - just the opposite of bonds using PV calculations. Matching the two essentially mitigates risk, locking in security of payments over time.
Duration matching does require ongoing efforts vs the lock-and-load method of zero-coupon bonds, since portfolio duration changes naturally as time passes. This can be used to any investor’s advantage in various horizon matching and contingency strategies. This is where you can match a certain level of your projected liabilities with duration strategies within certain thresholds. With a large portion of future cash flow needs targeted, a buffer can be used in active strategies to enhance the portfolio’s value. Of course, if the active management decisions do not pan out and the buffer is depleted, you can still rely on the dedicated portion of the portfolio to meet the primary needs.
This is an example of a very well-planned personal wealth strategy where liabilities are gradually eliminated using both dedicated strategies and asset allocation modeling.
Target Date Funds
One of the best portfolio dedication strategies used by individual investors is called target date funds, which have become popular in many 401k plans. These vary from traditional dedication, as they are based on asset allocation and historical patterns. They are a kind of a buy-and-hold strategy, where all the work is done for the investor by reducing riskier assets with cash and bonds as the target date approaches. It’s a simple, inexpensive method to match future cash-flow needs or retirement dates and theoretically walk away. The results of these funds have been mixed, mainly because of the way asset classes have behaved in the last 15 years and how they vary from what traditional CAPM modeling has projected.
Traditional dedication is obviously used more by institutions than individual investors, as asset allocation presides as the more popular strategy. Using the same base premise, asset allocation uses historical data to project future cash flows and returns, which can be reasonably matched to one’s own unique future.
Many sophisticated financial planning tools are available for investors to build the asset allocation that best suits their goals, which are in essence similar to liabilities to a pension fund. Like target date funds, asset allocation planning is a useful tool if the investor sticks to the plan, does not change strategy mid-stream and asset classes behave more like their historical patterns project.
To expect future returns within a reasonable projection range, investors need to follow simple strategic allocation rules to maintain proper asset class levels. Many investors fail or bail out of an asset allocation-based strategy by panicking at the wrong time and/or letting greed take over and not selling asset classes when they rise. This is an area of behavioral finance that looks deep into the mind of investors and their actions. For some investors, it’s nearly impossible to separate emotion from money, which is the most common reason those plans fail.
Portfolio dedication has been used in many forms by institutions and individuals alike. There are relatively precise methods to directly lock in an asset to a liability to remove any outside risk like immunization. Hybrid methods that use traditional duration matching and threshold setting allow some active management to add value. These strategies should be used in conjunction with asset allocation-based strategies, which are a combination of all the strategies together and used by institutions and individuals. Individual investors now have access to sophisticated tools that did not exist 20 years ago and can design individual plans to meet their unique needs.
The pitfall with these long-term plans is that individuals tend to react emotionally to short-term variations in asset class changes from historical norms.