Two-part semester class
The investment portfolio program is a two-semester program consisting of the Portfolio Management I (PMI) and the Portfolio Management II (PM II) classes. The PM I class focuses on fixed income securities, and the PM II class covers equity securities and client portfolio management. The class meets once a week with the PM I class from 5:30 p.m. to 6:50 p.m. The PM II class meets from 8:20 p.m. to 9:40 p.m. Board meetings are held every week between 7:00 p.m. to 8:10 p.m. during which the students manage the $1,000,000 fixed income portfolio.
Restrictions imposed by the bank are: Investments can be made in investment grade bonds only. If a bond is downgraded to below investment grade it needs to be sold within a reasonable time. Investment in a single firm should not exceed 3% of the portfolio. An exception can be made if bonds were held in two or more firms that merged. Because of exchange rate and other risks, investment cannot be made in foreign securities. An exception can be made for small amounts ($10,000 or less) if such an exception contributes to the learning process.
Guidelines for the fixed income portfolio are: The maximum investment in any industry is 20% of the portfolio. The portfolio should have an appropriate mix of high quality (AAA and AA) and medium quality (A and BBB) bonds. The portfolio should be laddered to reduce risk. Increase duration if interest rates are expected to fall, reduce duration if interest rates are expected to rise. Ensure yield to maturity and yield to worst are not less than 6% for AAA bonds. For lower grade bonds yields must be higher. This strategy is reviewed every semester and modified based on the interest rate environment. A general goal is to earn a yield equivalent to the loan rate plus 2%
Guidelines for the equity portfolio are: No more than 3% of the portfolio may be invested in an individual stock or mutual fund. The stocks should be diversified across industries. Mutual funds should be diversified across investment categories like domestic, international, large growth, mid-cap value etc. The core stock portfolio should consist of growth blue chip stocks, which are bought on a buy and hold basis, but are trimmed when prices rise significantly. Trading stocks should be identified in advance and sold at predetermined prices.
Significant changes have occurred in the way the portfolio is funded. On September 15, 1988 Local Oklahoma Bank, then Citizens Bank, entered into a loan agreement with the Cameron University Foundation. The loan of $500,000 was made to the Foundation to establish a student-managed fixed-income portfolio. The fixed-income securities purchased with the bank loan were pledged as collateral for the loan. The bank also indemnified the Foundation from any losses. The bank reserved the right to veto any investment decisions made by the board.
Interest Rate History
The interest rate charged by bank has changed several times. Changes are shown in Table 1. Table 1:History of Interest Rates September 1988 October 1992 November 1995 April 1996 July 1999 July 2001 3-month T-bill rate 3-month T-bill rate plus 2% 3-month T-bill rate plus 1% Conversion to loan to line of credit 3-month LIBOR plus 0.5% 3-month T-bill rate plus 1%
The first interest rate change occurred in October 1992 when the bank increased the interest rate on the loan by 200 basis points (2 percent). This steep interest rate hike transformed the portfolio from a profitable one to a losing proposition, particularly because a flattening of the yield curve followed the rate increase. The portfolio started losing money and instead of buying bonds, the class sold bonds that had yields below the loan rate. Eventually, the bank was persuaded to lower the interest rate to t-bill plus one percent in November 1995. This interest rate permitted the portfolio to operate at breakeven or slightly better. However, on the unused portion of the loan, the portfolio earned the money market rate, which was lower than the loan rate. Consequently the portfolio lost money on the unused portion of the loan. This resulted in sub-optimal investments because not investing would mean even higher losses.
In April 1996 the class proposed that the loan be converted to a line of credit, and the bank accepted the proposal. The conversion to a line of credit required interest to be paid only on the portion of funds being used. This immediately eliminated the losses on the unused portion of the loan. In July 1999 the bank changed the interest rate from the 3-month T-Bill plus 1% to the 3-month London InterBank Offer Rate (LIBOR) plus 0.5%. In July 2001, the loan agreement with Local Oklahoma Bank was not renewed and the Foundation entered into a similar agreement with BancFirst. The line of credit was increased to $1,000,000 and the loan rate was changed from LIBOR plus 0.5% to the 3-month T-Bill plus 1%.
Client Portfolio Project
In the past, client portfolio management was taught using case studies. Two years ago, a local broker persuaded a client to allow the class to analyze his and his wife's investment portfolio. This innovative method of teaching portfolio management has now been in operation for four semesters. During the first two semesters, local brokers provided the clients. During the last two semesters, clients have been recruited without using the services of a broker.
The portfolio management process is as follows: The class receives some background information about the client and a statement of the client's assets; it develops a set of questions to ask the client in order to prepare a formal investment policy statement; this investment policy statement includes the client's objectives such as return requirements, risk tolerance, and cash flow needs, as well as investment constraints such as time horizon, liquidity needs, tax considerations, regulatory constraints, and any unique circumstances.
The process of interviewing the client and compiling information for the investment policy statement is accomplished as a team. This process requires a fair amount of skill can be fairly difficult because of unrealistic expectations of clients or their inability to clearly communicate their investment objectives and constraints. Frequently clients can overstate or understate their risk tolerance. It is the job of the class to correctly deduce the client's needs by asking carefully selected questions. The completed investment policy statement is given to the client and, where applicable, to the sponsoring broker.
The class starts on asset allocation after receiving the client's approval on the investment policy statement. The goal of asset allocation is to meet the clients return requirements and cash flow needs, keeping in mind the objectives and constraints laid out in the investment policy statement. Multiple scenarios are prepared for different projected returns and inflation rates. The client's attention is drawn to the fact that in certain circumstances, the investment goals cannot be realized.
After the asset allocation process the class proceeds to security selection. The client's portfolio is analyzed to determine how well it conforms to the asset allocation model. Individual stocks and mutual funds are carefully evaluated to determine what changes are desirable. Every effort is made to meet the client's goals with minimum transactions. A preliminary report is prepared and a second meeting is held with the client. After obtaining client input on the preliminary report, the class prepares a final report and presents it to the client at the semester banquet.
Funding the portfolio using a bank loan/line of credit presented the students with many learning opportunities:
The previous bank had a tendency to unilaterally change interest rates on the loan at very short notice and the students had to regularly negotiate with the bank for more favorable terms. They had to build a convincing case to persuade the bank to reduce the loan rate or modify the loan agreement. The students were successful thrice: In November 1995, when the bank reduced the loan rate to T-Bill plus 1%. In April 1996, when the loan was converted to a line of credit without a change in rates. In July 2001 when the bank reverted to T-bill plus 1% from LIBOR plus 0.5%.
Most student-managed funds use money donated for the purpose or funds allocated by university endowments. The use of borrowed funds by Cameron presents students with the challenge of earning at least the loan rate to breakeven. The problem is complicated by the fact that the loan rate is a short-term variable rate, but the investments are made in a portfolio of short-term, intermediate-term and long-term fixed income securities. Every class discusses this problem at the beginning of the semester and sets the yield spreads required over the loan rate for bonds with different maturities and credit quality.
The change from a loan to a line of credit provided students with an additional decision variable - "to invest or not to invest." Under the loan agreement, the portfolio was fully invested, since the loan rate had always been higher than the money market rate. Under the line of credit, the class could sell bonds.