. 150
( 193 .)


in Figure 17.1 shows the percentage of the overall portfolio held in each asset.
This example illustrates a top-down approach that is consistent with the needs of large
organizations. The top managers set the overall policy of the portfolio by specifying asset
allocation guidelines. Lower-level portfolio managers fill in the details with their security
selection decisions.

Active versus Passive Policies
One choice that must be confronted by all investors, individual as well as institutional, is the
degree to which the portfolio will be actively versus passively managed. Recall that passive
management is based on the belief that security prices usually are at close to “fair” levels. In-
stead of spending time and other resources attempting to “beat the market,” that is, to find mis-
priced securities with unusually attractive risk-return characteristics, the investor simply
assumes that she will be fairly compensated for the risk she is willing to take on and selects a
portfolio consistent with her risk tolerance.3
Passive management styles can be applied to both the security selection and the asset allo-
cation decisions. With regard to asset allocation, passive management simply means that the
manager does not depart from his or her “normal” asset-class weightings in response to chang-
ing expectations about the performance of different markets. Those “normal” weights are
based on the investor™s risk and return objectives, as discussed earlier. For example, we saw
in an earlier box that Vanguard™s asset allocation recommendation for a 45-year-old investor
was 65% equity, 20% bonds, and 15% cash equivalents. A purely passive manager would not
depart from these weights in response to forecasts of market performances. The weighting
scheme would be adjusted only in response to changes in risk tolerance as age and wealth
change over time.
Next consider passive security selection. Imagine that you must choose a portfolio of
stocks without access to any special information about security values. This would be the case
if you believed that anything you know about a stock is already known by the rest of the in-
vestors in the market and therefore is already reflected in the stock price. If you cannot predict
which stocks will be winners, you should broadly diversify your portfolio to avoid putting all
your eggs in one basket. A natural course of action for such an investor would be to choose a
portfolio with “a little bit of everything.”
This reasoning leads one to look for a portfolio that is invested across the entire security
market. We saw in Chapter 2 that some mutual fund operators have established index funds
We discussed arguments for passive management in previous chapters. Here, we simply present an overview of
the issues.
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

17 Investors and the Investment Process

that follow just such a strategy. These funds hold each stock or bond in proportion to its rep-
resentation in a particular index, such as the Standard & Poor™s 500 stock price index or the
Lehman Brothers bond index. Holding an indexed portfolio represents purely passive security
selection since the investor™s return simply duplicates the return of the overall market without
making a bet on one or another stock or sector of the market.
In contrast to passive strategies, active management assumes an ability to outguess the
other investors in the market and to identify either securities or asset classes that will shine in
the near future. Active security selection for institutional investors typically requires two lay-
ers: security analysis and portfolio choice. Security analysts specialize in particular industries
and companies and prepare assessments of their particular market niches. The portfolio man-
agers then sift through the reports of many analysts. They use forecasts of market conditions
to make asset allocation decisions and use the security analysts™ recommendations to choose
the particular securities to include within each asset class.
The choice between active and passive strategies need not be all-or-nothing. One can pur-
sue both active security selection and passive asset allocation, for example. In this case, the
manager would maintain fixed asset allocation targets but would actively choose the securi-
ties within each asset class. Or one could pursue active asset allocation and passive security
selection. In this case, the manager might actively shift the allocation between equity and bond
components of the portfolio but hold indexed portfolios within each sector. Another mixed ap-
proach is called a passive core strategy. In this case, the manager indexes part of the portfolio,
the passive core, and actively manages the rest of the portfolio.
Is active or passive management the better approach? It might seem at first blush that ac-
tive managers have the edge because active management is necessary to achieve outstanding
performance. But remember that active managers start out with some disadvantages as well.
They incur significant costs when preparing their analyses of markets and securities and incur
heavier trading costs from the more rapid turnover of their portfolios. If they don™t uncover
information or insights currently unavailable to other investors (not a trivial task in a nearly
efficient market), then all of this costly activity will be wasted, and they will underperform a
passive strategy. In fact, low-cost passive strategies have performed surprisingly well in the
last few decades, as we saw in Chapters 4 and 8.

3. Identify the following conditions according to where each fits in the objective- Concept
constraints-policies framework.
a. Invest 5% in bonds and 95% in stocks.
b. Do not invest more than 10% of the budget in any one security.
c. Shoot for an average rate of return of 11%.
d. Make sure there is $95,000 in cash in the account on December 31, 2015.
e. If the market is bearish, reduce the investment in stocks to 80%.
f. As of next year, we will be in a higher tax bracket.
g. Our new president believes pension plans should take no risk whatsoever with
the pension fund.
h. Our acquisition plan will require large sums of cash to be available at any time.

Choosing the investment portfolio requires the investor to set objectives, acknowledge con-
straints, determine asset-class proportions, and perform security analysis. Is the process ever
finished and behind us? By the time we have completed all of these steps, many of the inputs
we have used will be out of date. Moreover, our circumstances as well as our objectives
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

616 Part SIX Active Investment Management

change over time. Therefore, the investment process requires that we continually monitor and
update our portfolios.
Moreover, even if our circumstances do not change, our portfolios necessarily will. For ex-
ample, suppose you currently hold 1,000 shares of ExxonMobil, selling at $65 a share, and
1,000 shares of Microsoft, selling at $80 a share. If the price of ExxonMobil falls to $50 a
share, while that of Microsoft rises to $90 a share, the fractions of your portfolio allocated to
each security change without your taking any direct action. The value of your investment in
ExxonMobil is now lower, and the value of the Microsoft investment is higher. Unless you are
happy with this reallocation of investment proportions, you will need to take some action to
restore the portfolio weights to desired levels.
Asset allocation also will change over time, as the investment performance of different as-
set classes diverges. If the stock market outperforms the bond market, the proportion of your
portfolio invested in stocks will increase, while the proportion invested in bonds will decrease.
If you are uncomfortable with this shift in the asset mix, you must rebalance the portfolio by
selling some of the stocks and purchasing bonds.
Therefore, investing is a dynamic process, meaning that you must continually update and
reevaluate your decisions over time.

SUMMARY • The Association for Investment Management and Research developed a systematic
framework for the translation of investor goals to investment strategy. Its three main parts
are: objectives, constraints, and policy. Investor objectives include the return requirement
and risk tolerance, reflecting the overriding concern of investment with the risk-return
trade-off. Investor constraints include liquidity requirements, investment horizon,
regulatory concerns, tax obligations, and the unique needs of various investors. Investment
policies specify the degree of involvement in market timing, asset allocation, and security
selection decisions.
• Major institutional investors include pension funds, mutual funds, life insurance
companies, nonlife insurance companies, banks, and endowment funds. For individual
investors, life-cycle concerns are the most important factor in setting objectives,
constraints, and policies.
• Major asset classes include: cash (money market assets), fixed-income securities (bonds),
stocks, real estate, precious metals, and collectibles. Asset allocation refers to the decision
made as to the investment proportion to be allocated to each asset class. An active asset
allocation strategy calls for the production of frequent market forecasts and the adjustment
of asset allocation according to these forecasts.
• Active security selection requires security analysis and portfolio choice. Analysis of
individual securities is required to choose securities that will make up a coherent portfolio

and outperform a passive benchmark.
• Perhaps the most important feature of the investment process is that it is dynamic.
Portfolios must be continually monitored and updated. The frequency and timing of
various decisions are in themselves important decisions. Successful investment
management requires management of these dynamic aspects.

KEY asset universe, 612 liquidity, 606 prudent investor rule, 607
TERMS endowment funds, 606 mutual funds, 603 risk aversion, 600
investment horizon, 607 personal trust, 602 risk tolerance, 600
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

17 Investors and the Investment Process

1. Your client says, “With the unrealized gains in my portfolio, I have almost saved enough
money for my daughter to go to college in eight years, but educational costs keep going
up.” Based on this statement alone, which one of the following appears to be least
important to your client™s investment policy?
a. Time horizon.
b. Purchasing power risk.
c. Liquidity.
d. Taxes.
2. The aspect least likely to be included in the portfolio management process is
a. Identifying an investor™s objectives, constraints, and preferences.
b. Organizing the management process itself.
c. Implementing strategies regarding the choice of assets to be used.
d. Monitoring market conditions, relative values, and investor circumstances.
3. A clearly written investment policy statement is critical for
a. Mutual funds
b. Individuals
c. Pension funds
d. All investors
4. The investment policy statement of an institution must be concerned with all of the
following except:
a. Its obligations to its clients.
b. The level of the market.
c. Legal regulations.
d. Taxation.
5. Under the provisions of a typical corporate defined-benefit pension plan, the employer is
responsible for:
a. paying benefits to retired employees.
b. investing in conservative fixed-income assets.
c. counseling employees in the selection of asset classes.
d. maintaining an actuarially determined, fully funded pension plan.
6. Which of the following statements reflects the importance of the asset allocation decision
to the investment process? The asset allocation decision:
a. helps the investor decide on realistic investment goals.
b. identifies the specific securities to include in a portfolio.
c. determines most of the portfolio™s returns and volatility over time.
d. creates a standard by which to establish an appropriate investment time horizon.
7. You are a portfolio manager and senior executive vice president of Advisory Securities
Selection, Inc. Your firm has been invited to meet with the trustees of the Wood Museum

Endowment Funds. Wood Museum is a privately endowed charitable institution that is
dependent on the investment return from a $25 million endowment fund to balance the
budget. The treasurer of the museum has recently completed the budget that indicates a
need for cash flow of $3 million in 2005, $3.2 million in 2006, and $3.5 million in 2007
from the endowment fund to balance the budget in those years. Currently, the entire
endowment portfolio is invested in Treasury bills and money market funds because
the trustees fear a financial crisis. The trustees do not anticipate any further capital
contributions to the fund.
The trustees are all successful businesspeople, and they have been critical of the
fund™s previous investment advisers because they did not follow a logical decision-
making process. In fact, several previous managers have been dismissed because of their
Bodie’Kane’Marcus: VI. Active Investment 17. Investors and the © The McGraw’Hill
Essentials of Investments, Management Investment Process Companies, 2003
Fifth Edition

618 Part SIX Active Investment Management

inability to communicate with the trustees and their preoccupation with the fund™s
relative performance rather than the cash flow needs.
Advisory Securities Selection, Inc., has been contacted by the trustees because of its
reputation for understanding and relating to the client™s needs. The trustees have asked
you, as a prospective portfolio manager for the Wood Museum Endowment Fund, to
prepare a written report in response to the following questions. Your report will be
circulated to the trustees before the initial interview on June 15, 2005.
Explain in detail how each of the following relates to the determination of either
investor objectives or investor constraints that can be used to determine the portfolio
policies for this three-year period for the Wood Museum Endowment Fund.
a. Liquidity requirements.
b. Return requirements.
c. Risk tolerance.
d. Time horizon.
e. Tax considerations.
f. Regulatory and legal considerations.
g. Unique needs and circumstances.
8. Mrs. Mary Atkins, age 66, has been your firm™s client for five years, since the death of
her husband, Dr. Charles Atkins. Dr. Atkins had built a successful newspaper business
that he sold two years before his death to Merit Enterprises, a publishing and
broadcasting conglomerate, in exchange for Merit common stock. The Atkinses
have no children, and their wills provide that upon their deaths the remaining assets
shall be used to create a fund for the benefit of Good Samaritan Hospital, to be called
the Atkins Endowment Fund.
Good Samaritan is a 180-bed, not-for-profit hospital with an annual operating budget
of $12.5 million. In the past, the hospital™s operating revenues have often been sufficient
to meet operating expenses and occasionally even generate a small surplus. In recent
years, however, rising costs and declining occupancy rates have caused Good Samaritan
to run a deficit. The operating deficit has averaged $300,000 to $400,000 annually over
the last several years. Existing endowment assets (that is, excluding the Atkins™s estate)


. 150
( 193 .)