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.Bodie, Zvi; Kane, Alex; and Marcus, Alan. Investments, 8th ed. McGraw-Hill Irwin, 2009, p. 538.Bodie, Zvi; Kane, Alex; Marcus, Alan. Essentials of Investments, 8th ed. McGraw-Hill Irwin, 2010, p. 344.Fabozzi, Frank. Bond Markets, Analysis, and Strategies, 3rd ed. Prentice Hall, 1996, p. 447.Fabozzi, Frank. The Handbook of Fixed Income Securities. McGraw-Hill, 2005, p. 1103.Jordan, Bradford and Miller, Thomas. Fundamentals of Investments. McGraw-Hill Irwin, 2009, p. 334.Logue, Dennis. Managing Corporate Pension Plans. Harper Business, 1991, p. 219.Sharpe, William; Alexander, Gordon; and Baily, Jeffery. Investments, 5th ed. Prentice Hall, 1995, p. 478.
History The most prolific author on dedicated portfolio theory, Martin L. Leibowitz,Fabozzi, Frank. Investing: The Collected Works of Martin L. Leibowitz. Probus, 1992, p. 521. 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. MacaulayMacaulay, Frederick R. Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields, and Stock Prices in the United States Since 1856. National Bureau of Economic Research, 1938, p. 44-53. 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. HicksHicks, J.R. Value and Capital, Clarendon Press (Oxford), 1939. independently developed a similar formulation referred to as the “average period.” In 1942, T.C. KoopmansKoopmans, T.C. The Risk of Interest Fluctuations in Life Insurance Companies. Penn Mutual Life Insurance Company, 1942. 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 SamuelsonSamuelson, Paul. The Effect of Interest Rate Changes in the Banking System. American Economic Review, March, 1945, p.16-27 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 British actuary, F. M. Redington.Redington, F.M. “Review of the Principles of Life-Office Valuations” Journal of the Institute of Actuaries 78, No. 3, 1952, p. 286-340. See also http://www.soa.org/library/proceedings/record-of-the-society-of-actuaries/1980-89/1982/january/RSA82V8N48.PDF
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 Security Prices.Fisher, Lawrence and Weil, Roman l. “Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies.” Journal of Business 44, No. 4 (October, 1971), P. 408-31. In 1972, I.T. VanderhoofI.T. Vanderhoof. “The Effects of Interest Rate Assumption and the Maturity Structure of the Assets of a Life Insurance Company.” Transactions of the Society of Actuaries, Volume XXIV, Meetings No. 69A and 69B, May and June, 1972, p. 157-92. 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 WeinbergerLeibowitz, Martin L., and Weinberger, Alfred. “Contingent Immunization.” Salomon Brothers, Inc. January, 1981. published a report on “contingent immunization” discussing the blending of active management of bond portfolios with immunization to provide a floor on returns. LeibowitzLeibowitz, Martin L. The Dedicated Bond Portfolio in Pension Funds - Part 1: Motivations and Basics and Part 2: Immunization, Horizon Matching and Contingent Procedures. Financial Analysts Journal, January/February (Part 1) and March/April (Part 2), 1986. 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.
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 in personal investing. This example is a couple who wants to retire this year (call it 20XY, such as 2018) and has already set aside cash to cover their expenses. Social security will supply some income, but the rest will have to come from their portfolio. They have accumulated a retirement portfolio worth $2,000,000 in addition to this year's expenses. 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 next 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 needs for 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 (called an "income matching bond ladder") 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 February 15 next year plus the coupon interest payments flowing from all the other bonds. The same would be true for the following 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. Whether the replenishment occurs every year automatically or only if other criteria are met would depend on the level of sophistication of the investor or advisor.
The 8 years of bonds can be thought of an “income portfolio” because it is dedicated to providing a predictable steam of income for the next 8 years. The rest of the portfolio can be thought of as a “growth portfolio” because it would be dedicated to providing the growth needed to replenish the income portfolio. The growth portfolio would presumably be invested in equities to achieve sufficient growth.
Recent research has sought to assess investment strategies designed from dedicated portfolio theory. Huxley, Burns, and FletcherHuxley, Stephen J., Burns, Brent, and Fletcher, Jeremy “Equity Yield Curves, Time Segmentation, and Portfolio Optimization Strategies,” Journal of Financial Planning, November, 2016, P. 54-61 explored the tradeoffs in developing suitable growth portfolio strategies. PfauPfau, Wade “Is Time Segmentation a Superior Strategy?” (4/3/17), www.advisorperspectives.com compared the performance of dedicated portfolios against other common investment strategies for retirement. In all comparisons, the dedicated portfolio approach provided superior results.