Investment Portfolio Analysis

INTRODUCTION
John Mesa, CFA, is a portfolio manager in the Trust Department of BigBanc. Mesa has been asked to review the investment portfolios of Robert and Mary Smith, a retired couple and potential clients. Previously, the Smiths had been working with another financial advisor, WealthMax Financial Consultants (WFC). To assist Mesa, the Smiths have provided the following background information.
Family: We live alone. Our only daughter and granddaughter are financially secure and independent.
Health: We are both 65 years of age and in good health. Our medical costs are covered by insurance.
Housing: Our house is in need of major renovation. The work will be completed within the next six months, at an estimated cost of $200,000.
Expenses: Our annual after-tax living costs are expected to be $150,000 for this year and are rising with inflation, which is expected to continue at 3 percent annually.
Income: In addition to income from the Gift Fund and the Family Portfolio (both described below), we receive a fixed, annual pension payment of $65,000 (after taxes), which continues for both of our lifetimes.
Financial Goals: Our primary objective is to maintain our financial security and support our current lifestyle. A secondary objective is to leave $1 million to our grandchild and $1 million to our local college. We recently completed the $1 million gift to the college by creating a "Gift Fund." Preserving the remaining assets for our granddaughter is important to us.
Taxes: Our investment income, including bond interest and stock dividends, is taxed at 30 percent. Our investment returns from price appreciation (capital gains) are taxed at 15 percent, at the time of sale. There are no other tax considerations. General Comments:
We needed someone like WFC to develop a comprehensive plan for us to follow. We can follow such a plan once it is prepared for us. We invest only in companies with which we are familiar. We will not sell a security for less than we paid for it. Given our need for income, we invest only in dividend-paying stocks.
Investments: We benefit from two investment accounts:
?The Gift Fund ($1 million) represents our gift to the college. During our lifetimes, we will receive fixed annual payments of $40,000 (tax free) from the Gift Fund. Except for the annual payments to us, the Gift Fund is managed solely for the benefit of the college?we may not make any other withdrawals of either income or principal. Upon our deaths, all assets remaining in the Gift Fund will be transferred into the college's endowment.
?The Family Portfolio ($1.2 million) represents the remainder of our lifetime savings. The portfolio is invested entirely in very safe securities, consistent with the investment policy statement prepared for us by WFC as shown in Exhibit 1:
Exhibit 1
WFC Investment Policy Statement for Smith Family Portfolio
The Smith Family Portfolio's primary focus is the production of current income, with longterm capital appreciation a secondary consideration. The need for a dependable income stream precludes investment vehicles with even modest likelihood of losses. Liquidity needs reinforce the need to emphasize minimum-risk investments. Extensive use of short-term investment-grade investments is entirely justified by the expectation that a low-inflation environment will exist indefinitely into the future. For these reasons, investments will emphasize U.S. Treasury bills and notes, intermediate-term investment-grade corporate debt, and select "blue chip" stocks whose dividend distributions are assured and whose price fluctuations are minimal.
Table 1

QUESTION
To assist in a discussion of investment policy, Mesa presents four model portfolios used by BigBanc; Table 1 applies the bank's long-term forecasts for asset class returns to each portfolio. Use Table 1, the Smiths' background information from the
Introduction and your knowledge of asset-class characteristics to:

A. Prepare and justify an alternative investment policy statement for the Smiths'
Family Portfolio. [Do not provide a specific asset allocation in your response to
this question.]

B. Describe how your investment policy statement addresses three specific deficiencies in the WFC investment policy statement shown in Exhibit 1.

C. Recommend a portfolio from Table 1 for the Family Portfolio. Justify your
recommendation with specific references to: i. three portfolio characteristics in Table 1 other than expected return or yield. [No calculations are required.] ii. the Smiths' return objectives. Show the calculations.

The Smiths now raise a new concern: "How can we judge whether our investment policy
statement is appropriate for us and whether it will continue to be appropriate in the
future?" Author Charles Ellis has suggested several questions that test the
appropriateness of an investment policy, including:
Is the policy written clearly and explicitly?Can the client sustain his/her commitment to the policy?Can the manager maintain fidelity to the policy?

Ellis has also noted that responsibility for investment policy is often misplaced.
D. Respond to the Smiths' questions as follows:
II. Describe how each of Ellis' three policy questions is or is not relevant to
the Smiths and why the WFC investment policy is or is not appropriate in light of
each of Ellis' three policy questions.
III. Recommend to the Smiths who should have responsibility for their
investment policy and for changes in that policy.