6 Things You Must Remember About Dedicated Portfolios
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Dedicated portfolios, also referred to as structured portfolios, are based on a cash flow matching dedication strategy. This approach aims to generate stable cash flows to match the anticipated liabilities of the future. The portfolio derives its name from the fact that it is dedicated to providing a minimum flow of cash to meet the payouts. The portfolio involves investment in bonds and other fixed-income assets, which create a system to exactly support payment needs over time. This is considered a safe investment strategy, especially for people nearing retirement. But it can have many implications too and hence, must be executed with care.
Here are six important things an investor should remember before investing in dedicated portfolios:
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1. Choose Investment-Grade Securities
The main hype about dedicated portfolios is that they provide stable returns over time. These inflows can be used to pay off impending liabilities. But this advantage of structured portfolios is solely dependent on the chosen funds. For a dedicated portfolio, it is critical to pick investment-grade securities and income-producing assets which reduce the risk of default. Investment-grade securities are assets that have a credit rating of BBB or higher, according to the Standard and Poor’s scale. Moreover, a Baa3 and higher rating, according to Moody’s, is also a safe asset in this regard. Typically, these involve government and private fixed-income funds, such as government and corporate bonds, notes, mortgage-backed securities, etc. Investment-grade assets have a very low risk of volatility. And thereby, assure a specific return to the investor. This, in turn, is beneficial to pay off future obligations. That said, it is also important to know that because these securities guarantee a specific return, the percentage of yield is very low as compared to other market securities, including equities.
2. Construct Wisely
A major hurdle in dedicated portfolios is their construction. Framing cash-flow matching strategies, demands high-level fixed-income expertise, extremely reliable analytics, a near-to-accurate insight of future capital outlays, and a deep understanding of the optimization theory. The portfolio should be structured to exactly map the maturity of funds to the cash flow, at the least possible cost. This extreme level of mathematical programming needs to be combined with thoughtful professional financial planning. It will help in selecting funds and deciding the horizon, amount, maturity, and other aspects. Hence, dedicated portfolios are time-consuming and also need extensive practical market knowledge to provide successful returns. Moreover, the investor needs to articulate financial goals, estimate liabilities and set a period. Then accordingly, assign a monetary value to each, to be pitted against cash inflows. To accurately estimate liabilities, it is important to determine the income required in the years of retirement. And then subtract the Social Security benefits or other incomes from it. The amount derived is the money needed to be withdrawn from retirement accounts each year to sustain the standard of living. Thus, the portfolio should at least meet future liabilities (required net income). A poorly constructed portfolio will defeat the whole purpose of this investment strategy. And in the case of a retiree, the lack of planning might cause a complete loss of funds in the most demanding years of life.
3. Engage for the Long-Term
Another critical aspect of dedicated portfolios is that investments in corporate bonds, government bonds, and other similar instruments are held for a long period to generate maximum returns. It is best to secure these funds up until their maturity. The aim is to establish a supply of coupons, which is ideal for matching payments for a definitive time in the future. This is also a type of immunization strategy, where the investor gives up active management for an assurance that the portfolio will provide the desired results. An ideal way for this is to invest in zero-coupon bonds. And specifically, relate the maturity of these bonds to the date of the cash flow requirement. By matching the asset and liability duration, the dedicated strategy should be able to mitigate risk and provide immunization against the changes in the interest rate.
4. Be Prepared for a Loss of Opportunity
A dedicated or structured portfolio is passively managed. This implies that there is a rare need for rebalancing assets. Passive or index portfolio management is a more laid-back approach than active management. This particular perspective aims to replicate a specific index, against which the assets of the portfolio are benchmarked. This helps to minimize risk and ensure stable rewards, thereby fulfilling the purpose of the investor. But in this course, the aim is to not outperform the benchmark. This results in a loss of opportunities when the value of assets appreciates in the market. Moreover, the structured portfolio leaves the investor stuck in the same bonds for years, ultimately forgoing all the lucrative market upturns as the market is agnostic to the needs of the investor. Further, if the purchase of assets is made while the market is on the rise, there is no flexibility to buy at a better opportunity later.
5. Garner Stable But Low Returns
Before venturing into a dedicated portfolio, it is critical to remember that even though this strategy promises a stable influx of money, it has low returns in comparison to other equity-based portfolios. The basis of this approach is allocating funds in investment-grade securities. Hence, there is only a defined window of returns. The assets involved are bonds and other secure instruments which have a lower risk but a guaranteed return. However, the average profit is lesser when compared to other allocation strategies that involve more equity-based assets. These equity-linked instruments offer a higher churn of profits but at the cost of high risks.
6. Be Prepared for a Restricted Choice
Dedicated portfolios only offer a limited choice for the investor. Since, these portfolios involve investments in high-grade securities, with less risk and stable returns. The overall choice of such assets becomes very limited. Even though debt instruments are considered a suitable investment for this purpose, there are not many that qualify the required criteria. Broadly, not all types of bonds are suitable for a structured portfolio. For instance, a callable bond, also known as a redeemable bond, is not fit for this purpose. These debt instruments will lead to an uncertain inflow of cash, which will have to be realigned further with the defined cash outflows.
To Sum it Up
Overall, a dedicated portfolio is a very thoughtful strategy. It requires the investor to be precise with future liabilities and take the utmost care in the selection of assets in the present. The ultimate aim is to match liabilities with assets to secure the future years of retirement. If the dedication strategy is constructed by keeping in mind the above-mentioned aspects, the portfolio is likely to minimize various risks. These include the market, reinvestment, inflation, default, and liquidity risk. However, the suitability of this methodology depends on the financial goals, time horizon, and the broad monetary condition of the investor. To optimize this strategy and gain a full advantage, investors can seek guidance from professional financial advisors.
