Mapping investments to liability structure Source: BUSINESS LINE (18-OCT-10)

We strongly believe that a portfolio should be constructed based on investment objectives, not on expected returns.

Returns are means to achieving an investment objective, not the reason for creating a portfolio. The question is: How can individuals create portfolios to meet their investment objectives?

This article shows how individuals can construct custom-tailored portfolios to meet liability structures. Such `Target Portfolios` can reduce price risk at the horizon and also help in efficient use of investment capital.

Liability Matrix
We define `Target Portfolio` as one that is created to meet pre-defined liability structure. Take a middle-aged investor. She may have the following requirement: Higher education expenses for her child 10 years hence, medical expenses for the family on continual basis, buying a house five years hence and retirement in 15 years.

Given that liabilities carry different priorities, we divide them into 2 categories - `Must-have` and `Should-have`.

`Must-have` liability ranks high in priority and is needed to maintain and improve individual``s standard of living.

The `Should-have` category includes liability structures which are required, but whose consumption can be deferred.

We likewise divide the liability horizon into long maturity and short maturity, where short maturity refers to liabilities with maturity less than or equal to 5 years.

Based on priority and maturity, we arrive at a 2 X 2 matrix- Long maturity `Must-have`, Long maturity `Should-have`, Short maturity `Must-have` and Short maturity `Should-have`. This matrix helps in creating Target Portfolios. To understand how the Liability Matrix helps in creating Target Portfolios, consider this: The investment portfolio required for education has a different characteristic from that required for retirement.

For one, the maturity of the education portfolio is less that of the retirement portfolio. For another, risk tolerance for the education portfolio is lower. This is because an investor requires money for higher studies when her child turns 18. Retirement can, however, be postponed or advanced.

From the above, it would be clear that the education portfolio would carry less exposure to risky assets than the retirement portfolio. Another important factor is the initial capital allocated to achieve each liability structure- higher the capital, lower the need for the portfolio to have exposure to risky assets.

This is the primary argument in creating Target Portfolios- each liability structure carries a different maturity, initial capital and risk characteristic that demands different investment structure.
Target Portfolio
How should investors create Target Portfolios? We list below the five-step process to constructing such portfolios.

First, the investor has to identify important liabilities she expects to incur during her lifetime. This would include pre-retirement and post-retirement liabilities.

Second, the investor has to estimate cash flows required to meet each such liability. This process will be easy when the liability relates to buying a house. It would be difficult to estimate liabilities that lead to continual cash flow requirement- medical expense, for instance.

Third, the investor has to decide the risk tolerance level for each liability. The `Must-have` liability will carry less tolerance for risk than `Should-have` liability.

Fourth, the investor has to decide on the capital to allocate for each portfolio. The required return for each Target Portfolio will be that return which enables investment capital to appreciate to the liability payments at the horizon.

Fifth, the investor has to calculate the expected return on various asset classes. Mapping the expected return on the asset classes with the required return on investment helps in the asset allocation decision. Investors should typically choose from equity, bonds, commodities and real estate.
Conclusion
Some Target Portfolios can be set-up using core-satellite framework. Target Portfolios help investors evaluate lifestyle needs and map investments to the liability structure. This helps in effective utilization of investment capital, as it is rationed based on priorities. Investors, thus, increase the probability of achieving the required investment value at each liability date.