Dedicated portfolio theory
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.
In his sketch of its history, he traces the origin of immunization to Frederick R. Macaulay[9] who first suggested the notion of “duration” for fixed income securities in 1938.
[13] This body of work was largely ignored until 1971, when Lawrence Fisher and Roman Weil[14] re-introduced immunization to the academic community in a journal article that followed a 1969 report written for the Center for Research in Securities Prices.
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.
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.
[citation needed]Table 2 shows series of bonds and CDs with staggered maturities 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).
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.
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.
Recent research has sought to assess investment strategies designed from dedicated portfolio theory.
Huxley, Burns, and Fletcher[18] explored the tradeoffs in developing suitable growth portfolio strategies.
Note that the fixed income securities shown in the example are high quality, safe “investment grade” fixed income securities, CDs and government-sponsored agency bonds, all chosen to avoid the risk of default.
But they have lower yields, meaning a portfolio of Treasuries to meet the same flows would cost more than CDs and agencies.
Also, triple-A rated corporate bonds have become scarce since the financial crisis of 2008 over the wide range of maturities needed for dedicated portfolios.
Investors willing to take greater risks may use any quality of bond deemed acceptable in light of their higher yields, though safety would likely be of paramount importance for retirement.
Another problem with “zeros” is that taxes must be paid each year on the increase in value of a zero-coupon bond (assuming it is held in a taxable account), even though no interest was actually received.
Because the dates and amounts of the coupon and redemption payments are known in advance, individual bonds held to maturity offer something few other financial investments can provide: predictability.
This need for specificity forces anyone contemplating a dedicated portfolio investment strategy to put careful thought into developing a formal, lifetime financial plan, as opposed to merely relying on vague or hazy goals and hoping for the best.
Advocates of active management believe that better returns are achieved by trying to time the market and selecting hot stocks (in other words, trying to predict the future).
Most academic research suggests that passive management has, in fact, historically produced higher returns over the long run.
Dedicated portfolios fall into the category of passive management because once bonds are purchased, they are held to maturity.
