digital.library.unt.edu/67531/metadc... · belt, brian, an investigation into the determinants of...

211 N&U Ho. HO 1

AN INVESTIGATION INTO THE DETERMINANTS OF

PERFORMANCE IN THE DUAL-FUND INDUSTRY IN THE

UNITED STATES FROM INCEPTION THROUGH 1973

DISSERTATION

Presented to the Graduate Council of the

North Texas State University in Partial

Fulfillment of the Requirements

For the Degree of

DOCTOR OF PHILOSOPHY

By

Brian Belt, 33.I.E., M.S., M.B.A,

Denton, Texas

December, 1976

Belt, Brian, An Investigation Into the Determinants of

Performance in the Dual ~ Fun d Indus try in the United states

from Inception Through 1973. Doctor of Philosophy (Manage-

ment), December, 1976, 279 pp., 27 tables, 9 figures, bibli-

ography, 144 titles.

This research is a systematic, in depth empirical test of

the strong form of the efficient market hypothesis (EMH) using

the dual-fund industry as the research subject. Unlike most

strong-form EMH research, this study deals with a small, homo-

geneous sector of the investment company industry with a com-

parable origin date. To obtain homogeneity of the research

subjects, the sample size is necessarily small (7), thus,

making it difficult to find statistically significant re-

sults .

Within the framework of general systems theory and the

view of management as a process, the portfolio management pro-

cess (PHP) is developed. The PMP is used as the framework for

systematically analyzing the portfolio management in the dual

funds.

The analysis of the dual funds shows substantial variation

of performance; this variation holds true whether averaged

arithmetic return, geometric return or risk-premium-to-vari-

ability is used as the performance measure. The inter-year

performance rankings within the dual-fund industry show a very

weak dependence over time (this correlation is only significant

at the 25% level). Analysis of the portfolio characteristeric

lines indicates that two of the dual funds generated returns

greater than that predicted by the capital asset pricing model

(CAPM) while three others generated returns less than that pre-

dicted by the (CAPM). No non-linearity is found in any of the

portfolio characteristic lines indicating that no dual fund

had consistently superior or inferior market predictive power.

About 7 5 7 o of the variation in returns of the dual-fund

industry is explained by variation in risk. Since the dual

funds were not well diversified during the interval, the vari-

ability of returns and not the volatility of returns (0) must

be used as the relevant risk measure. In addition, the vola-

tility of returns (0) for some of the dual funds varied over

the time period due to changes in portfolio policy. The man-

agement of the dual funds did not use 3 widely as a rxsk mea-

sure.

In general, portfolio performance is negatively correlated

with variability in measures of portfolio characteristics such

as the major mix, common stock categories, portfolio turnover,

etc. The better-performing dual funds were more consistently

managed while the lower-performing companies had significant

and sometimes frequent changes in portfolio policies. In

line with the efficient market hypothesis, "passive" management,

i.e., low turnover, few changes in major mix or common stock

composition, shows better results in the dual-tund industry

from inception through 1973.

The qualitative analysis assists in describing why port-

folio managment followed certain policies. The initial pro-

spectuses, periodic reports, and portfolio management question-

naires are individually inconclusive concerning the causes of

differential performance; collectively, they provide substan-

tial background and meaning to the quantitative results.

The portfolio management process (PHP) provides a useful

framework for systematically analyzing both the quantitative

and qualitative aspects of portfolio management in the dual-

fund industry. In spite of the systematic and rigorous study

into the dual-fund industry, the results generally support the

efficient market hypothesis (EMH) and the capital asset pricing

model (CAPM). That is, systematic analysis of the PMP could

not explain differential performance in the dual-fund industry

except that differential performance associated with differen-

tial risk accepted.

TABLE OF CONTENTS

Page

LIST OF TABLES v

viii LIST OF FIGURES •

CHAPTER

I, INTRODUCTION AND DEFINITION OF PROBLEM . . . . . 1

Introduction An Introduction to a Model of

The Portfolio Management Process (PMP) Definition of Research Problem Research Outline

II. EXPERIMENTAL RESEARCH DESIGN 16

Introduction The Dual-Fund Industry Experimental Design

III. REV IE?/ OF RELEVANT LITERATURE . . . 61

Introduction U. S. Capital Markets and Their Efficiency Portfolio Management Review of the Dual-Fund Industry

1 oq IV. RESEARCH RESULTS . . . . . . . .

Introduction Quantitative Research Results Summary

V. CONCLUSIONS AND RECOMMENDATIONS FOR FUTURE RESEARCH 1 9 8

Summary and Conclusions Recommendations For Future Research

i n

Page

APPENDICES:

A. Portfolio Characteristics and Measures: Definitions and Mathematical Formulas . . 213

B. Variable Values Used For Regression Analysis 222

C. Sample of Dual-Fund Portfolio Management Questionnaire . 226

D. "PORTEVAL" Computer Program Listing and Sample Output 23

E. Summary of Dual-Fund Portfolio Management Questionnaires 247

BIBLIOGRAPHY 269

iv

LIST OF TABLES

Table P a& e

I. Portfolio Management Process (PMP) Description 10

II. Summary of Pertinent Dual-Fund Investment Company Data 21

III. Required Portfolio Return, yt, Compared to Portfolio Net Asset Value (NAVt), Assuming a 6% Guaranteed Dividend and Management Fees and Expenses are a Constant 0.7% of NAV^

IV, Quantitative Variables Considered as Determinants of Portfolio Performance . . 34

V. Framework for Portfolio Management Organizations 98

VI. Decision Matrix Illustrating Appropriate Portfolio Policy for Existing Forecasting Ability 100

VII. Portfolio Management Functions According to Several Authors Ill

VIII. Required Return Each Dual Fund Must Earn To Cover Minimum Obligations to Income Shares 118

IX. Dual Fund Performance Measures: Mean of Annualized Returns, Risk Premium to Variability, Annualized Geometric Return, as Well as Industry Rank for Each Performance Measure 125

X. Dual Fund Cumulative Gross Portfolio Return Since Inception—Percentage and Industry Rank . . * 127

XI. Dual Fund Annualized Gross Portfolio Return— Percentage and Industry Rank for Each-Year Since Inception 128

Table P aS e

XII. Number of Years From 1967 to 1973 That Each Dual-Fund Had Annualized Gross Returns Greater Than Total Return For Dow-Jones Industrial Average (DJIA) and Standard & Poor's 500 Stock Index (S&P 500) . . . . 130

XIII. Slope (S) And Intercept (a). And Coefficient 0f Determination Portfolio Characteristic Lines Measured Against S&P 500 Index . . . 131

XIV. 95% Confidence Intervals for "True" a and 3 For Dual Fund Portfolio Characteristic Lines Against S&P 500 INDEX Through 1973 . 134

XV. Comparison Of Gross Arithmetic Return (AM) And Risk For Dual-Fund Industry Against S&P 500 Through 1973 135

XVI. Coefficients of Second-Order (Parabolic) Portfolio Characteristic Lines For Dual-Fund Industry Against S&P 500 And Comparison Of "Goodness Of Fit" 137

XVII. Comparison Of Buy-And-Hold Strategy For Each Dual Fund Versus Actual Returns For Period December 31, 1967 To December 31, 1973 139

XVIII. Intercept, Slope, And2Coefficient of Determination (r ) For Linear Regression Of Each PMP Variable Against Arithmetic Mean Return. • 142

XIX. Average Arithmetic Returns For Various Market Sectors As Measured By Different Market Indices For March 31, 1967, To December 31, 1973 150

XX. Average Portfolio Size And Management Fees And Expenses For The Period From March 31, 1967 to December 31, 1973 158

XXI. Summary Of Multiple Regression Analysis For Each PMP Stage And Entire PMP For Dual-Fund Industry From March 31, 1967, to December 31, 1973. . 159

XXII. Investment Objectives And Policies For Dual-Fund Industry Taken From Initial Prospectuses I®5

vi

Table

XXIII.

XXIV.

XXV.

XXVI.

XXVII.

Initial Investment Restrictions As Specified In Original "Prospectus" For Each Dual Fund

Initial Investment Restrictions As Specified In Original "Prospectus" For Each. Dual Fund

Annualized Dividend Yield For S&P 500 Composite Stock Index And Minimum Yield Objective (MYO) For "GEM" and "HEM" .

Comparison of Perceived Organizational Quality Versus Performance Within Dual-Fund Industry . .

Real Estate Investment Trusts (REITs) By Type, Number, And Year Of Origination

Page

L68

169

171

192

211

VI i

LIST OF FIGURES

Figure Page

1. Portfolio Management as a Basic System . . . . . 5

2. Portfolio Management Process (PMP) 9

3. General Illustration of how Dual Funds Work . . 19

4. The Relationship Between Market Efficiency and the Resources Used in Security . . . . 81

5. Hypothetical Efficient Frontier for Capital Markets . . . 87

6. Portfolio Theory Approach to Portfolio Analysis and Portfolio Selection 89

Trust Investment Process (TIP) developed by Clarkson - . • • •

8. Investment decision as presented by Mennis

104

107

9. The Portfolio Management Process (PMP) within its many environments 1 x 0

viii

CHAPTER I

INTRODUCTION AND DEFINITION OF PROBLEM

Introduction

Portfolio management as the term has developed in the

United States refers to the management of sets of financial

assets. Financial asset management is similar to the

management of human resources and/or physical assets in that

a continuous process of planning, executing, and controlling

is the central focus. The process of portfolio management,

then, is quite similar in many respects to the process of

managing other types of assets, e.g., human, physical, etc.

However, portfolio management differs in certain

important aspects from the management of human resources

and/or physical assets. Managers of financial assets buy

and sell products (i.e., financial assets) that are generally

standardized and interchangeable. The transactions of an

individual portfolio manager typically do not affect prices

in the broad capital markets as they buy or sell the

financial assets that make up their portfolios. In

addition, portfolio managers find it difficult to obtain or

develop information whose content gives them a significant

competitive advantage over other portfolio managers;' in

fact, a major element of the "efficient market hypothesis"

is that current market prices reflect all known information

concerning any financial asset (see Chapter III for

discussion and references).

To simplify, portfolio managers deal with standardized

types of assets in large, broad markets where important

information is easily available and widely disseminated. In

short, portfolio managers buy and sell assets in markets 2

that approximate "purely competitive" conditions. In

contrast, managers of human assets can be selective in the

inputs and can expend substantial resources to further train

and develop their resources, i.e., they can control their

output markets as well as the transformation process, and

can direct their human resources to specifically selected

output markets. Similarly, managers of physical assets are

able to select specific assets, develop or integrate them as

they see fit, and can select the applicable output markets.

In the competitive but concentrated industrial and commercial

world of today, managers of human resources and/or physical

assets can exert substantial control over their markets;

individual portfolio managers typically cannot.

"*"For example, see James H. Lorie and Mary T. Hamilton, The Stock Market: Theories and Evidence (Homewood, Illinois, 1973), pp. 100-5.

2Richard H. Leftwich, The Price System and Resource Allocation, 4th Ed. (Hinsdale, Illinois, 1970), pp. 26-7.

Portfolio managers, thoiigh, are not helpless corks

floating at the mercy of the impersonal capital markets.

Appropriate timing of asset acquisition and divestiture as

well as judicious selection of various classes of financial

assets (or of individual financial assets) may prove quite

profitable; however, inappropriate actions usually bring

unsatisfactory results.

Financial literature frequently shows that, in aggregate,

professional money managers — usually represented by

managers of publicly-owned investment companies — fail to

perform better than specified market indices or even randomly

3

selected portfolios. This alleged poorer performance

exists whether the performance measure is presented in terms

of: (1) absolute return; (2) return relative to some measure

of risk; or (3) return that is in excess of a "risk free"

market instrument compared to some measure of risk.

That professional money managers in aggregate

apparently have failed to exceed market averages or randomly

selected portfolios has led some authors to infer that

portfolios should not be managed at all. Instead, some

authors suggest that securities should be randomly selected

and held. These inferences are an example of the fallacy of

composition -- i.e., "what is true of a part is, on that

account alone, alleged to be also necessarily true of the

^Lorie, op, cit., pp. 70-112, 198-210, 228-259.

whole-'4 Hence, if all portfolios were randomly selected

because of the high level of market efficiency, then market

efficiency would necessarily be reduced and money managers

could no longer depend on randomly selected portfolios

producing adequate results. Still a valid question exists

whether managing a single portfolio is a useful endeavor,

and, if so, to what extent.

An Introduction to a Model of The Portfolio Management Process (PMP)

The management of a portfolio is clearly the management

of a system. The portfolio itself is part of the larger

capital market system; at the same time, the portfolio

contains elements that can be arranged in various sub-

systems within the portfolio. Within the framework of a

basic system, the management of a portfolio resembles the

model illustrated in Figure 1. The output of the system is

a unified portfolio managed to accomplish the objectives of

the ultimate owners of the assets. A portfolio is "an array 5

of components designed to accomplish a particular objective,"

i.e., a portfolio is a system.

4Paul A. Samuelson, Economics, 8th Ed. (New York, 1970), p. 12.

5Richard A. Johnson, et. al., The Theory and Management Systems, 3rd. Ed. (New York: McGraw-Hill, 1973), p. 117.

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(1) objectives; (2) performance measures; (3) environments;

(4) constraints; (5) resources; (6) components; and

(7) management.® This study considers each element for portfolio

management.

First, the objective of the portfolio is to satisfy

the ultimate owners of the portfolio. This portfolio

objective must be related to both the wealth and income

position of the investor, the desired wealth and income

position of the investor, and the risk/return possibilities

available in the capital markets. Second, performance is

indicated with measures of both return and risk. Since

returns from financial assets are believed to be primarily

a result of the risks incurred in ownership, comprehensive

measures of performance must include both return and risk.

Next, the portfolio exists in numerous overlapping

environments , each creating its own set of constraints. The

capital market environment defines the feasible outcomes;

the legal environment indicates what alternatives are

permissible in the eyes of the law. The investors themselves

define an environment with differing objectives, policies,

and constraints. The environment internal to a portfolio

management organization itself provides limits — through

both written and unwritten policies — on alternatives and

6C. West Churchman, The Systems Approach (New York: Delacorte Press, 1968), pp. 29-30.

even objectives. The fourth element, constraints, follows

directly from, and is determined by, the environment in

which the portfolio operates.

Fifth, the portfolio has numerous resources. The

portfolio includes the initial capital provided by the

investors. From this point, the portfolio draws on the

human resources of the portfolio managers, the informational

resources from both internal and external sources, subsequent

capital contributions by shareholders, and energy. The

energy includes both the mental and physical effort of

portfolio managers as well as the energy necessary for

interacting with the various environments.

The sixth element of the portfolio system is its

component structure. The components of a portfolio could

be broken into: different classes of securities, e.g.,

fixed-income versus common stock; different maturity dates*

various categorizations of assets by industrial classification;

as well as many other possible sub-structures. The primary

managerial force behind the portfolio is the portfolio

management organization. This seventh and last system

element can itself be broken into structural components,

e.g., by functional responsibility, or by some other

organizational breakdown.

Portfolio management is an iterative and sequential

process that includes several unique stages: (1) portfolio

planning; (2) investment analysis; (3) initial portfolio

selection; (4) portfolio revision; and (5) portfolio

evaluation.7 Figure 2 illustrates the sequencing and

interrelationships of the stages; the major managerial

functions of planning, executing, and controlling are shown

with the associated portfolio management process (PMP)

stages.

A further description of the PMP is presented in Table

I. Note that each stage has unique inputs and outputs as

well as major functions (i.e., transformations) that are

contained therein. Clearly each step in the PMP is an

integral element in the overall process.

For the purposes of this research, the Portfolio

Management Process (PMP) that is shown in Figure 2 will be 8

used as a "global model" of portfolio management. The

PMP shown in Figure 2 is a global model in the sense that

the decision-making process of investment management is

broken into basic elements and then re-integrated by

illustrating the interrelationships of these distinct

steps.9 All analysis — whether quantitative or qualitative

— will be made with reference to the PMP. Further analysis,

justification, and theoretical development of the PMP is

found in Chapter III.

7Keith V. Smith, Portfolio Management (New York, 1971), pp. 40-55.

8Ibid., pp. 40-43. 9Ibid., p. 40.

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Definition of Research Problem

As stated previously, much of the literature indicates

that in the aggregate, professional portfolio managers do

not perform as well as might be expected considering the

resources allocated. However, much of the literatuie is

"macro" in viewpoint looking at large numbers of portfolios

to determine if persistent differences in performance ;

exist; in contrast, a "micro" analysis which used the

portfolio management process as the basis of analysis would

permit investigations that could provide insights into the

causes of differential portfolio performance. Such research

should lead to a better understanding of the impact of the

various stages of the PMP, as well as the interactions

between stages, on portfolio performance.

Portfolio managers — like all managers — must work

within certain constraints as opposed to randomly selected

portfolios or market indices. The more the constraints

affect the PMP, the greater may be the loss of potential

performance. Alternative actions would allow successful

adaptation to changing environments. A more comprehensive

"^For example, the most widely known studies are: Jack L. Treynor, "How to Rate Management of Investment Funds," Harvard Business Review, 43 January-February, 1965), 63-75, ?«.i:lXiam F. Sharpe, "Mutual Fund Performance," Journal Journal of Business, Security Price-: A Supplement, 39 Part 2 (January, 1966), 119-38; Michael C, Jensen, "Risk, The Pricing of Capital Assets, and The Evaluation of Investment Portfolios," Journal of Business, 42 (April, . 1969), 167-247.

12

review and analysis of the effects of constraints on per-

formance is presented in Chapter III. The first stage of

the portfolio management process — portfolio planning -- is

where the "Constraints of Money and the Mind" appear and

become ingrained into the portfolio management process.

Administrative, legal, and mental constraints are established

in the portfolio planning stage and often remain essentially-

unchanged throughout the existence of the managed portfolio.

In an era of efficient and professional security analysis,

portfolio selection/revision, and portfolio evaluation, the

initial stage of the PMP appears to be a particularly fruitful

area of research — within, the context of the portfolio

management process — for describing the causes of differential

portfolio performance.

Therefore, the research problem is to determine if

portfolio management materially effects portfolio performance.

In addition, if portfolio management can be broken into

distinct stages, which stage, which set of interacting stages,

or what combination of factors most effects performance.

The research described herein is a systematic and intensive

analysis of a selected number and type of portfolios whose

similarities make possible the development and testing of

research hypotheses.

^Iiarry C. Sauvain, Investment Management, 4th Ed. (Englewood Cliffs, N.J., 1974), pp. 307-326.

13

Research Hypothesis

The general hypothesis to be tested by the proposed

research is:

The portfolio management process directly and materially effects portfolio performance. Further, differential portfolio performance can be explained by a systematic analysis of the parts as well as the whole of the portfolio management process.

The results of a thorough analysis into this hypothesis

could provide valuable inputs to investors so that they

might be able to establish the relationship between

performance and any proposed portfolio management process.

In line with the previous discussion concerning the

nature, formulation, and effect of investment constraints,

a secondary hypothesis is:

In relatively efficient security markets with highly trained and motivated participants, differential port-folio performance is primarily determined by the initial stage of the portfolio management process, the portfolio planning stage.

The research described in this study is an in-depth,

quantitative and qualitative analysis testing the above

hypotheses. The theoretical context of this research is one

of a descriptive viewpoint of the decision processes; hence,

little emphasis is placed on: (1) prescriptive model

building; or (2) descriptive analysis of either the behavioral

12

environment or the decision maker(s) themselves. The set

of portfolios to be used for study is the dual-fund segment

12 "Fremont E. Kast and James E. Rosenzweig, Organization

and Management, 2nd Ed. (New York, 1974), pp. 348-9.

14

of the investment company industry; the dual-fund industry

is a small but homogeneous part of the investment company

industry. The dual-funds were all begun within the last

decade so that substantial information exists concerning

the portfolio planning stage. The "dual-funds" were

selected due to a variety of factors more fully explained in

Chapter II. The analysis of the performance of these port-

folios is made within the context of the portfolio management

process (PMP) described earlier in this chapter (see

Figure 2 and Table I).

Research Outline

The following four (4) chapters describe both the

research methodology and the results of this research on

the portfolio management process (PMP) in the dual-fund

industry. Chapter II is entitled the "Experimental Research

Design" and covers: (1) a discussion of the dual-fund

industry and the reasons why it was selected; (2) the

experimental design; and (3) the limitations <3f the research.

Chapter III is a review of the relevant literature; included

in this discussion are sections dealing with: (1) the efficient

market hypothesis and research results of testing the

hypothesis; (2) portfolio management; and (3) important

research materials on the dual-fund industry. Chapter IV,

"Research Results," contains two sections: first is a

discussion of the results of the quantitative analysis of the

15

dual-fund industry; the second part of this chapter is a

review and analysis of the qualitative study. The fifth

and final chapter is entitled "Conclusions and Recommendations

for Future Research;" this is the capstone summary of the

entire research effort.

CHAPTER II

EXPERIMENTAL RESEARCH DESIGN

Introduction

This chapter is broken into three main sections. The

first section describes the dual-fund industry with

particular reference to the rationale behind selecting the

dual-fund industry for this research. The second major part

of the chapter describes the experimental design utilized

in this research; the experimental design includes two

subsections. The first subsection is a quantitative study

that emphasizes analysis of portfolio characteristics

versus measures of portfolio performance. The second part

of the experimental design describes the qualitative study

of the portfolio management of the dual funds. The last

major chapter section describes the research limitations.

The Dual-Fund Industry

The research performed on actual portfolio results

can be broken into two broad categories: broad study of

a large number of different portfolios or an intensive

16

17

study of a limited number of portfolios.1 Although

extremely informative, the results of the latter research

are more difficult to generalize with respect to portfolio

management in general. The best known research is that

dealing with the analysis of large numbers of portfolios—

usually investment companies. The large number of portfolios

provides a statistical base adequate for making inferential

statements; however, aggregating many diverse portfolios

together stretches the ability to categorize precisely.2

For example, different mutual funds have different objectives;

Wiesenberger provides a categorization system for different

types of objectives, but clearly no one would claim that all

3

funds within a category have precisely the same objective.

In addition, each fund began at a different point in time,

making difficult a comparison of the initial portfolio

Examples of the former are: Irwin Friend, Marshall Blume, and Jean Crockett, Mutual Funds and Other Institutional Investors (New York, 1970); William F. Sharpe, "Mutual Fund Performance," Journal of Business, 39 (January, 1966), 119-38; Michael D, Jensen, "Risk, The Pricing of Capital Assets, and The Evaluation oi Investment Portfolios," Journal of Business, 42 (April, 1969), 167-247. An example of the latter is: Carleton C. Page, "Investment Policies and Rates of Return of Selected Teacher Retirement Systems", Unpublished Dissertation, Bloomington, Indiana (1970).

2 Simon criticizes the above referenced study by Friend on

these grounds: "The Wharton study may have suffered from the great variety in the characteristics of the mutual funds," Julian L. Simon, "Does 'Good Portfolio Management' Exist?" Management Science. 15 (February, 1969), B-308.

3 For an example of research utilizing the Wiesenberger

categorization, see John C. Bogle, "Mutual Fund Performance* Evaluation: Conventional vs. UnconventionalFinancial Analysts Journal, 26 (November, 1970), 25-334.

18

selection as well as the subsequent portfolio revision. A

desirable research dealing with the causes of portfolio

performance should analyze a reasonably large set of

investment companies that have similar characteristics,

have comparable origination date:s, as well as portfolio goals

that can be compared as objectively as possible. The dual-

fund industry is such a set of investment companies.

Concept of Dual Funds

Dual funds are internally leveraged, closed-end

investment companies. The leverage of the dual funds comes

from two distinct types of corporate shares—income or

preferred shares and capital shares. All portfolio income,

minus expenses, flows solely to the income shares, whereas,

the capital gains (or losses) are accumulated in the portfolio

and will be distributed solely to the capital shares upon A

dissolution of the investment company." The planned

dissolution of the investment company is relatively novel

among closed-end investment companies and should tend to

keep Net Asset Value (NAV) per share and the market prices in

line, particularly as the dissolution date approaches; the

dissolution dates range from 13-18 years from inception.

Figure 3 illustrates the general procedure of dual-fund

operation.

4 For a concise summary and history of the dual-fund

concept, see: Carol J. Loomis, "Those Loaded, Double-Barreled Closed-End Funds," Fortune, 81 (February, 1967), 201-206. Also, a special section in the article section oi the bibliography includes a selected bibliography on dual funds.

19

Income Snares Caoital Shares

Total'Assets

$212 Total Assets -100 Income Shares "|Tl2 Net Assets for

Capital Shares +1236 Annual Gain

Expected Long-term Results:

6% Yearly Capital^ Appreciation = $12

3% Yearly Income = $6

$6 Dividend +6% Annual Yield

for Income Shares

Figure 3. General Illustration of how Dual Funds work

20

By applying an internal leverage procedure within the

company, both classes of stock potentially can benefit from

each other. There are no periodic fixed charges such as

interest; however, the dividends to the income share holders

are generally "guaranteed" and cumulative at about 5-6% of

the initial subscription price. Seven funds were established

in 1967 but the public reception and relatively complicated

tax procedures for capital share accounting on accumulated

gains discouraged the formation of other dual funds. Only

two more U.S. dual funds—exchange funds—have joined the industry

since 1967. Information about the seven original dual funds

is given in Table II. Throughout the rest of this paper,

each dual fund is referenced by the respective stock symbol

shown in Table II.

Background.—The inauguration of the first dual funds was

5

preceded by substantial publicity. Some of the best known

names in the investment management field were associated with

the new dual funds, names such as John Bogle, George Johnston,

George Putnam, and Gerald Tsai. The names of the funds

themselves were indicative of what some hoped for in terms

of results: Gemini and Hemisphere. Several authors

concluded that many more dual funds would be created—either

by starting new funds or by converting existing closed-end

5 For example, "Dual Funds Ready to Go," Business Week

(March IS, 1967), 150; Henry Ansbacher Long, "Enthusiastic Reception for New Dual-Purpose Funds," Trusts and Estates, 106 (February, 1967),'145-6.

21

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22

P

funds. The dual-fund idea was imported from Britain, as

was the extra gimmickry to enhance initial fund sales—

escalating preferred dividend (PUTNC) or paying preferred

shareholders back more at fund termination than the fund

netted at inception (ADV, ICS, and PUTNC).1

The initial performance of the dual funds was closely 8

monitored and widely publicized. In spite of the publicity,

both the capital and income shares sold at discounts from

net asset value like most other closed-end funds; investors

lost interest in buying new funds and the underwriters turned

Ira U. Cobleigh, "The New Two-To-One Capital/Income Funds," The Commercial and Financial Chronicle, 205 (April 6, 1967), 9;"Cobleigh felt that many dual funds would be created and some closed-end investment companies would convert to dual funds. Edwards felt that dual funds would replace closed-end companies or at least force them to permit redemption at net asset value per share; Robert G. Edwards, Jr., "New Double-Duty Funds—A Threat to Closed-Ends?" The Commercial and Financial Chronicle, 205 (April 13, 1967), 3.

^Loomis, o£. cit. Q

The following are examples of early reporting of results (listed by publication date): John P. Shelton, Eugene F. Brigham, Alfred E. Hofflander, Jr., "An Evaluation and Appraisal of Dual Funds," Financial Analysts Journal, 23 (May, 1967), 131-139: Joseph Netter, II, "Dual-Purpose Funds: One Month Later," Financial Analysts Journal, 23 (July, 1967), pp. 85-87. "Dual-Purpose Fund Results," Fortune, 82 (August, 1967), 176-6; James A. Gentry and John R. Pike, "Dual Funds Revisited," Financial Analysts Journal, 24 (March, 1968), 149-157.

23

Q

their efforts to other endeavors. Only two other dual

funds were created in the United States after the original

seven began; each was an exchange fund: Scudder Duo-Vest

Exchange Fund and Federated Dual-Exchange Fund (later

renamed "Pegasus"). Neither of these dual funds is

included in this research due to the unusual nature of

constructing the initial portfolio of exchange funds.

Portfolio Management Considerations.—To qualify as a

regulated investment company, dual funds must derive at

least 90% of their income from dividends, interest, etc.;

derive less than 30% of their income from securities held

less than three months; and exhibit an appropriate degree of

diversification. In addition, to avoid paying corporate

taxes on income, net income must flow to the shareholders

(income shares in this case). Each dual fund retains capital

gains in the portfolio, pays the associated Federal Income

Tax, and "flows" the tax credit through to the capital share-

Q

The sale of new closed-end funds is more difficult when existing competing closed-end shares can be purchased at a discount from net asset value. "There has been little reason for an investor to purchase new shares at net asset value, when he could buy outstanding shares at a discount from net asset value." Richard Fishbein, "Closed-End Investment Companies", Financial Analysts Journal,25 (March, 1970), 68.

"^The two exchange funds are discussed in: Henry Ansbacher Long, "Hybrids Feature Last Call for Exchange Funds", Trusts and Estates, 106 (May, 1967), 487-8.

24

holders. ""*"

Since the capital structure of these companies includes

senior shares with guaranteed cumulative dividends, the

portfolio managers need to meet the dividend requirements

so that no restrictive measures will be undertaken by the

income shareholders. To accomplish this, the managers need

to generate income according to the following equations:

NAVt (yt - et) >. D where: NAV^ =

and D = (NAV ) where 0

portfolio net asset value in period "t"

required portfolio yield in period "t"

% management fees and expenses in period "t"

total $ amount of required dividends

nominal dividend rate on income shares

NAV = original portfolio net asset value

D

o

therefore: y, > ) +

(NAVt)

e,

Assuming a 6% "guaranteed" dividend to income share-

holders and 0.7% management fees and expenses, the required

yt, would be related to the current portfolio value, NAV^,

as indicated in Table III. The required income return, y+,

"^For an example of how the tax credit is handled by the investment company and shareholders, see: George A. Christy and John C. Clendenin, Introduction to Investments, 6th Ed. (New York, 1974), pp. 495-6.

25

TABLE III

REQUIRED PORTFOLIO RETURN, y±, COMPARED TO PORTFOLIO NET ASSET VALUE (NAVt), ASSUMING A 6% GUARANTEED DIVIDEND

AND MANAGEMENT FEES AND EXPENSES ARE A CONSTANT

0.7% OF NAVt

Portfolio Value, NAVt, Minimum Required as a Percentage of Portfolio Original Net Asset Return,

Value, NAVq Y-t

40% . 8.20%

60% 5.70%

80% 4.45%

100% . 3.70%

120% 3.20%

140% 2.84%

1.60% 2.58%

180% 2.37%

200% 2.20%

'% 1.70%

26

is inversely related to changes in portfolio value. In

addition, because of the fixed cost of management fees and

expenses, the required yield, y , goes up (down) faster

than the portfolio value goes down (up). For example, if

portfolio value declines 40% from original value, the

required percentage cash return goes up 54%.

Other than the income-generation situation described

above, the dual-fund managers are relatively free of

constraints. Since all seven funds had initial assets in

the $30-100 million range, each fund manager should have

been able to buy and sell securities without affecting

market conditions severely in comparison with a major bank

trust department, for example. As with all closed-end

companies., maintaining a highly liquid position is

unnecessary because there are no redemptions (or new share

12

sales). Therefore, periodic "window dressing" is not

needed and management can concentrate on those securities

that they really feel are best regardless of current 13

"popularity" or lack of it. Diversification constraints

12 "Closed-end investment companies do not have to concern

themselves with redemptions, and consequently, they are in a position to make substantial commitments to illiquid invest-ments," Fishbein, op. cit., 71. Charles D. Ellis in "Portfolio Operations," Financial Analysts Journal, 27 (September, 1971), 36, makes a similar statement that portfolios with substantial capital flows make maintaining portfolio "character" difficult.

13 Simon, op. cit., 309, lists several reasons why

closed-end investment companies are particularly useful for research on portfolio management.

27

are the same as for all regulated investment companies —5%

maximum in one security and no more than 10% of any out-

standing security issue. Hence, as long as the dual funds

meet the legal constraints imposed on all regulated

investment companies and maintain the previously discussed

income requirements, then the portfolio manager is relatively

free to pursue the interests of the capital share owners.

Rationale for Selecting Dual-Fund Industry

The dual-fund sector of the investment company area was

selected for the following reasons: first, the dual funds

were inaugurated recently enough to analyze the very

important initial stage of the portfolio management process—

portfolio planning. Similarly, each of the seven funds

began operations within five months of each other, thereby

creating a comparable basis for analyzing portfolio selection,

Second, the dual-fund industry was introduced with a

substantial amount of interest by the investment company

industry as well as academia. However, performance within

the group has been quite dissimilar. Third, the dual-fund

industry is homogeneous in terms of size, capital structure,

time-in-existence, planning horizon, as well as other

important structural characteristics. Fourth, the period

from inception through 1973 for these investment companies

is approximately seven years; therefore, sufficient data is

available to gauge the longer-term performance of this

28

industry. The management of these companies has

remained essentially the same throughout the period so that

meaningful time-related, intra-company comparisons are

possible.14 Last, in spite of the academic interest in the

dual funds, little recent research has been published about

the level and causes of performance in the dual-fund industry.

The dual-fund industry represents the only truly

comparable set of portfolios for which information is

publically available. If portfolio management does materially

affect portfolio performance, the dual-fund industry

represents the best set of portfolios for analyzing across

both different portfolios as well as over time to determine

what—if anything—affects performance. As such, the dual-

fund industry is selected for this research.

In addition, the time frame under analysis is of

particular interest. From mid-1967 until the end of 1973,

stock prices changed very little; for example, the Dow Jones

Industrial Average declined slightly from 860.26 to 850.86.

Although stock prices changed very little over the period,

there were two substantial up markets (1968 and mid 1971 to

the end of 1972) and two severe bear markets (1969 through

early 1970 and 1973). The substantial market fluctuations—

14 Barineau brings out this problem while commenting on

research by Simon, o£. cit. : "the reliability of the author's conclusion would seem to rest on the implicit assumption. . . that the six trusts used in the test were managed by the same individuals throughout the 26-year test period and thus followed the same policies." John N. Barineau, "Critique of: "Does 'Good Portfolio Management' Exist?" Management Science, 15, (February, 1969), B-320.

29

along with significant interest rate fluctuations—created

many opportunities for superior or inferior management to

produce returns indicative of the underlying managerial skill.

The seven-year interval under study is long enough so that

15 short-term fluctuations should not alter conclusions.

Experimental Design

The performance of any portfolio can be described by a

variety of methods. Absolute performance indicates the total

returns generated for a specific period. Performance

appraisal based on absolute measures is suspect on two

grounds. First, reference must be made to the "risk" of the

portfolio; and second, consideration must be given to returns

available from alternative investment opportunities.

These considerations give rise to the concept of

"relative" performance. Performance measures can be developed

that compare returns to market indices (e.g., the Standard and

Poor's 500 Stock Composite Index) or are relative to sane measure

of risk. A third view of performance is to compare what was

15 The seven-year interval seems adequate although there

is. no optimal period for analysis. In discussing research by W. Scott Bauman, G. Walter Woodworth says: "Five-year periods are doubtless too short" for measuring performance of mutual funds, W. Scott Bauman, "Evaluation of Prospective Investment Performance," Journal of Finance, 23(May, 1968), 296. On the other hand, "d requirement that the study cover at least ten years brings on further problems because ten years is a long time to expect the investment philosophy, vitality, experience, and quality of personnel, etc., to remain constant," Frank E. Block, "Risk and Performance," Financial Analysts Journal, 22 (March, 1966), 70. '

30

accomplished with the objectives. This would be particularly

useful for evaluating the performance of the management of

real or human assets since relative comparisons are not

readily available for either comparable standards or risk

measures.

In the course of describing what determined the perfor-

mance for the dual-fund industry, each of the above described

viewpoints of performance is considered. Absolute and

relative measures of performance are used primarily in the

quantitative analyses while comparing results to nominal

16

objectives is discussed in the qualitative section.

The remainder of the experimental design section of this

chapter is broken into three areas. The first area defines

the quantitative measures of performance; included in this

section is the discussion of the regression of portfolio

characteristics against the performance measures. The next

section analyses the portfolio characteristic line for each

dual fund. The third and last component of the experimental

design section covers the qualitative research.

Quantitative Measures of Performance and Regression Analysis

The quantitative measures of portfolio performance are

three in number; each is defined mathematically in Appendix A.

16 Since this study is primarily empirical research,

reference should be made to Friend and Vickers' comment: "the ultimate assessment of portfolio management...must lie in the investment performance realized," Irwin Friend and Douglas Vickers, "Portfolio Selection and Investment Performance," Journal of Finance, 20 (September, 1965), 392.

31

The average gross arithmetic return is calculated before

management fees and. expenses. Also calculated, is the

geometric return from inception through 1973. The geometric

return better reflects actual results than does the average

arithmetic return;"^ unlike the arithmetic return, the 18

geometric return never over-states actual performance.

The third measure of performance integrates both a

relative concept and a measure of risk. Sharpe's composite

measure, is equal to the "ex post" yield minus a measure

of risk-free return, all divided by the intertemporal 1Q

standard deviation of returns. " Hence,

The advantages of the geometric return are discussed in Keith V. Smith, Portfolio Management (New York, 1971) pp. 82-84, 177-179, 183-184. For this research, each portfolio has been "unitized" in line with Smith's discussion on page 179; each "unit" is one (1) income share (see definitions in Appendix A) and the associated capital shares.

18The fact that the arithmetic mean is always greater than or equal to the geometric mean—and, therefore, may overstate^ actual returns—is illustrated in Franco Modigliani and Gerald A. Pogue, "An Introduction to Risk and Return: Concepts and Evidence," Financial Analysts Journal, 30 (March 1974) 69.

"^Deciding on a measure of risk is extremely difficult. For example, "Not everyone agrees on how to define risk, let alone how to measure it." Modigliani and Pogue, op. cit., 70. In this research, the standard deviation around the arithmetic return is used as a measure of risk; although this definition has widespread usage (e.g., Friend and Vickers, o£. cit., 394), there are alternative possibilities for a quantitative measure of risk. The standard deviation measures variability of returns--both above and below the expected return; however "it is not variation 'per se' which constitutes risk, it is decline in price or value," James H. Lorie, "Some comments on Recent Quantitative and Formal Research on the Stock Market," Journal of Finance, 39 (January, 1966), 108. Some other measures suggested are: "mean absolute deviation" used in "Measuring the Investment Performance of Pension Funds for the

32

Y - Rf

$ = _ where: Y = average annual yield ky over T prior periods

Rf = risk-free rate of return

S = standard deviation of y y over t periods

20 R^ is established at 5% for the period under study." Phi

($•) can be interpreted as the excess portfolio return per unit

y'

21 of "ex post" risk (S ). The standard deviation was used

as a measure of risk as opposed to volatility (8), since the

use of 8 assumes the portfolio is efficient—a factor that is

Purpose of Inter-Fund Comparison," Bank Administration Institute, Park Ridge, Illinois (1968); or semi-standard deviation in Harry Markowitz, Portfolio Selection: Efficient Diversification of Investments (New York: 1959), Chapter 9. Sharpe's original formulation of his composite measure, $ is found in: William F. Sharpe, "Mutual Fund Performance," Journal of Business, 39 (January, 1969), 119-138.

90 The average, quarterly yield on 90-day U.S. Treasury

bills was approximately 6% during the 1967-73 time period; however, the 5% interest rate used in this research was available to portfolio managers at least 70% of the interval under analysis, 1975 Historical Chart Book, Board of Governors, Federal Reserve System (Washington, D. C., 1975), p. 98.

21 The excess yield to variability measure is widely used

in portfolio research. In addition to Sharpe, op. cit., see Haim Levy, "Portfolio Performance and the Investment Horizon," Management Science, 18, (August, 1972), B-646, Treynor's Index (TI), the excess return to volatility, "cannot capture the portion of variability that is due to lack of diversification; for this reason it is an inferior measure of past performance," Sharpe, ojd. cit. , 128. Other alternatives measures of performance are available; "A significant restriction on the applicability of the reward-to-variability criterion results from the fact that it utilizes only the first two moments of the probability distribution of returns," 0. Maurice Joy and R. Burr Porter, "Stochastic Dominance and Mutual Fund Performance," Journal of Financial and Quantitative Analysis, 9 (January, 1974), 25.

33

tested in the research concerning the portfolio characteristic

line.

In line with the research hypothesis (see Chapter I),

performance is assumed to be a function of certain variables

and takes the following form:

P = f (X-p . . . , X ) where: P = measure of performance

and

X^,. . . , XR = causal variables

The exact form of the assumed relationship is the linear model.

P = aiX. + a0Xn + . . . a„X + K where: a1s . . , a„ are -L l & ct nil x n

the regression coefficients K is the constant in the regression equation.

The variables X- through XR are defined relative to a specific

stage of the portfolio management process (PMP) as shown in

Figure 2 and described in Table I. Table IV lists all of

the variables used in this phase of the research; each is

numbered sequentially within the respective PMP stages (See

Figure 2 and Table I). All variables are defined

mathematically in Appendix A. Each variable is calculated

for each of the seven dual funds.

34

TABLE IV

QUANTITATIVE VARIABLES CONSIDERED AS DETERMINANTS OF PORTFOLIO PERFORMANCE

PHP Stage Variable Designation Portfolio Stage Characteristic

Portfolio Planning (Initial Planning)

Portfolio Planning (Continuing Planning)

Investment Analysis

Management Fee (%) Initial Minimum Cash Portfolio Yield (%) [before Mgt, Fees and Expenses]

Average Minimum Cash Portfolio Yield (70) [before Mgt. Fees and Expenses]

Average - Required Return to Fund Termination (%) [before Mgt. Fees and Expenses]

Initial Minimum Cash Portfolio Yield (%) [including Mgt. Fees and Expenses]

Average Minimum Cash Portfolio Yield (%) [including Mgt. Fees and Expenses]

Average Required Return to Fund Termination (%) [including Mgt. Fees and Expenses]

Maximum Planning Portfolio Size ($)millions)

Interest as Percentage of Port-folio Income (%)

Average Annual Gross Portfolio Yield (X)

Average Annual Required Minimum Current Yield (%)

Average Annual Excess Current Yield (7.)

Average Percentage of Portfolio in Vickers Favorite Fifty (%) [same as PR10]

Average Percentage of Portfolio in Dow Jones Industrial Stock (%) [same as PR11]

Average Senior Securities (pre-ferred stocks and bonds) to Net Asset Value (%) [same as PR2]

TABLE IV—Continued

35

Portfolio Selection

Portfolio Revision

PS1

PS2

PS3

PS4

PS 5

PS6

PS7

PS8

PS9

PS10

PSli

PS12

PS13

PR1

PR2

PR3

Initial Cash and Marketable Secu-rities to Net Asset Value (7=)

Initial Senior Securities (pre-ferred stocks and bonds) to Net Asset Value (7»)

Initial Convertible Securities to Net Asset Value (7>)

Initial Senior Securities plus Common Stocks of Publically-regulated Utilities to Net Asset Value (7o)

Initial Common Stock to Net Asset Value {%)

Initial Percentage of Financial Common Stocks and Securities Convertible into Common Stock (7o)

Initial Percentage of Transpor-tation Common Stocks and Secu-rities Convertible into Common Stock (%)

Initial Percentage of Utility-Common Stocks and Securities Convertible into Common Stock

Initial Percentage of all Other Common Stocks and Securities Convertible into Common Stock (%)

Initial Percentage of Vickers Favorite 50 to Common Stocks and Securities Convertible into Common Stock (7>)

Initial Percentage of Dow Jones Industrial to Common Stocks and Securities Convertible into Common Stock (7S).

Initial Number of Security In-vestments (excluding cash and equivalents)

Initial Dollar Amount Invested per Security Investment ($)

Average Percentage Cash and Marketable Securities to Net Asset Value (%)

Average Percentage Senior Secu-rities to Net Asset Value (%) [same as IA3]

Average Percentage of Convert-ible Securities to Net Asset Value (%)

TABLE IV—Continued 36

Portfolio Revision (cont.)

PR4

PR5

PR6

PR7

PR8

PR9

PR10

PR11

Portfolio Evaluation

PR12

PR13

PR14

PE1 PE2 PE3 PE4 PE5 PE6 PE7 PE8 PE9 PE10 PE11 PE12

Average Percentage of Senior Securities Common Stocks plus Publically-regulated Utilities to Net Asset Value {%)

Average Percentage of Common Stocks to Net Asset Value {%)

Average Percentage of Financial Common Stocks and Securities Convertible to Common Stocks

Average Percentage of Transpor-tation Companies to Common Stocks and Securities Convert-ible into Common Stocks (%)

Average Percentage of Utility Common Stocks and Securities Convertible into Common Stocks

Average Percentage of all Other Common Stocks and Securities Convertible into Common Stocks <%)

Average Percentage of Vickers Favorite 50 to Common Stocks and Securities Convertible into Common Stocks (7«) [same as IA1]

Average Percentage of Dow Jones Industrial to Common Stocks and Securities Convertible into Common Stocks {%) [same as IA2]

Average Number of Security In-vestments (excluding cash and equivalents)

Average Dollar Amount Invested per Security Investment ($) thousands)

Average Annual Turnover (%) [same as PE13]

Intertemporal Intertemporal Intertemporal Intertemporal Intertemporal Int er temp oral Intertemporal Intertemporal Intertemporal Intertemporal Intertemporal Intertemporal

Standard Standard Standard Standard Standard Standard Standard Standard Standard Standard Standard Standard

Deviation Deviation Deviation Deviation Deviation Deviation Deviation Deviation Deviation Deviation Deviation Deviation

of PR1 of PR2 of PR3 of PR4 of PR5 of PR6 of PR7 of PR8 of PR9 of PRIG of PR11 of PR12

37

TABLE IV—Continued

PMP Stage Variable Designation Portfolio Stage Characteristic

Portfolio Evaluation (cont.)

PE13

PE14

PE15

PE16

PE17

PE18

PE19

PE20

PE21

PE22

Intertemporal Standard Deviation of PR13






Average Mgt. Fees and Expenses Per 6 Months ($ thousands)

Average Excess Current Return (%) [same as CP4]

Average Annual Turn-over (%) [same as PR14]

Average Percentage Management Fees and Expenses (%)

Portfolio Planning Variables.—Variables related to

portfolio planning are broken into two distince areas of

planning—initial planning (IP) and continuing planning

(CP). The information source for the IP variables is the

initial prospectus for each dual fund. The planned percentage

management fee (IP1) is a portfolio planning decision set by

the investment company founders. To meet the guaranteed

38

preferred dividends the portfolio had to generate adequate

cash income. The initial minimum cash yield (IP2)

considers what returns were necessary to meet initial

requirements while the average minimum cash yield (IP3)

takes into account the fact that certain of the dual funds

had guaranteed preferred dividends that increased over

time. Certain dual funds also committed themselves to

paying the preferred shareholders more at fund termination

than was paid in by the original preferred share purchasers.

This additional amount has to be made up over the life of

the relevant dual fund from the fund principal. The average

required return to fund termination (IP4) equals IP3 plus

the annual amortized amount of the preferred share

increase.

IP2, IP3, and IP4 exclude reductions in the income

stream due to management fees and expenses. IP5, IP6, and

IP7 are equivalent to IP2, IP3, and-IP4 except that the

proposed management fee plus 0.2% for expenses is added to

22 IP2, IP3, and IP4 respectively. The last initial portfolio

22 An excellent discussion of the constraints

imposed by income on portfolio management is given in: Henry C. Sauvain, Investment Management, 4th Ed. (Englewood Cliffs, N. J., 1973), pp. 297-306.

39

planning variable is the maximum planned portfolio size

(IPS).23

The continuing planning phase of portfolio planning

obviously is related to the initial stage, but differs in

that performance could have increased or reduced the

principal. The portfolio managers could meet the income

requirement through either dividends or interest; a measure

of this decision—the percentage of gross income derived

from interest—is CP1. Average annual gross portfolio

yield (CP2) indicates average cash income available to meet

the guaranteed preferred dividends, management fees, and

expenses. The average annual required minimum current yield

(CPS) compares semi-annual dividend requirements, management

fees, and actual expenses to period-ending net asset value.

The average annual excess current yield (CP4) is equal to

CP2 minus CP3. This measures how much excess or deficit

income exists; income deficits constrain management to

income-oriented investments while income surpluses free

management from an income orientation.

Investment Analysis.—The investment analysis stage of

PMP is the least amenable to the development of quantitative

portfolio characteristics. This situation exists because

most investment analysis does not show directly in the <>

23 The relationship between performance and fund size is

analyzed in: Irwin Friend, Marshall Blume, and Jean Crockett, Mutual Funds and Other Institutional Investors (New York, 1970), pp. 60, 156.

40

portfolio itself and, when it does, may occur in some later

period. As a result, only a limited number of investment

analysis variables are definable.

The average percent of portfolio net asset value

invested in Vickers "Favorite 50" (IA1) is an indication of

whether the investments are made in currently popular

securities. The average percentage of portfolio net asset

value invested in securities listed in the Dow-Jones

Industrial Average list (IA2) is a measure of the extent

24

that investments are made in "blue chip" securities. At

any point in time, securities may be on both lists

simultaneously. The average percent of senior securities in

the portfolio (IA3) is an indication of whether fixed-income 25

or variable-return securities are being analyzed and used.

Portfolio Selection.—The initial portfolio selection

variables are derived from the first portfolio reported

to the public. This first publicly available portfolio 24 A valid measure of the investment "quality" for a

portfolio is difficult to develop. Wagner and Lau used Standard and Poor's Earnings and Dividend Rankings as a measure of security quality, W. H. Wagner and S. C. Lau, "The Effect of Diversification on Risk," Financial Analysts Journal, 27 (November, 1971), 48. An attempt was made in this research to develop a portfolio "quality" measure, but at least one-third of the stocks listed in dual-fund portfolios had no S&P ranking.

25 For a discussion of the selection of an appropriate

mix of fixed-income/variable-income securities within the context of portfolio management, see Peter 0. Dietz, "Com-ponents of a Measurement Model: Rate of Return, Risk, and Timing," Journal of Finance, 23 (May,.1968), 268-9. Mix variables are also used in both the portfolio selection and portfolio revision stages.

41

always occurs within 100 calendar days of the initial public

offering for each dual fund.

The initial percentage of net asset value in cash

and marketable securities (PS1) indicates the initial desire

to maintain liquid assets. The initial percentage of senior

securities (preferred stocks and bonds) to net asset value

(PS2) indicates what mix between common equity and senior

securities management sought initially. Convertible

securities were considered by some to be ideal investments

since convertibles have a constant income stream and the

possibility of capital appreciation; therefore, PS3 is the

percentage of net asset value initially invested in

convertible securities.

Common stocks and securities convertible into common

stocks could be invested in common stocks of publicly

regulated utilities as an alternative to senior securities.

Some investors often view regulated utility shares as

primarily income-oriented securities.; therefore, PS4 is the

initial percentage of net asset value in senior securities

and common stocks of publicly-regulated utilities. The

percentage of net asset value invested initially in common

stocks is PS5 (PS1 + PS2 + PS5 = 100%). PS6, PS7, PS8, and

PS9 are the percentages of common stocks and securities

convertible into common stocks invested in financial,

transportation, utility, and all other common stocks and

equivalents, respectively (PS6 + PS7 + PS8 + PS9 = 100%).

42

Specific companies are assigned to industries on the basis of

Standard and Poor's classifications.

A measure of whether the initial common stock selection

was made from stocks popular with investment companies is

PSll--the initial percentage of common stocks invested in

common stocks listed on Vicker's "Favorite 50". An

indication of initial portfolio quality is given by the

percentage of common stocks and equivalents invested in

securities listed in the Dow Jones Industrial Average. The

initial percentage of either the Vickers "Favorite 50" or

Dow Jones Industrial Average refers to the respective list as

of the date of the first public report of portfolio position

for each dual-fund.

One important portfolio decision is the concentration

of resources into a relatively small number of investments

or spreading resources into a large number of investments.

The initial number of security investments (as of first

publicly-reported position) indicates the degree of

concentration or diversification. Cash and equivalents are

not counted; therefore, PS12 is the number of separate issues

of common stocks, preferred stocks, and bonds. Since the

dual funds differed somewhat in initial size, the larger

funds may have had a correspondingly larger number of

investments to maintain the same diversification or

concentration. To account for different-sized funds, PS13

43

is the initial dollar amount invested per security investment

(cash and equivalents are omitted from both dollar amount

numerator—and number of investments—denominator).

Portfolio Revision.—All changes in portfolio position

beyond the initial portfolio selection represent decisions

made in the portfolio revision stage of the PMP (see Figure

2 and Table I). Therefore, the variables of interest

cover the entire time frame of analysis—inception through 1973

The same basic variables described in the previous section

are used again except that average values for the entire

period are used instead of initial values.

One problem with the view of management as a process

is the difficulty in clearly assigning certain functions to

a specific stage in the managerial process (see Chapter III).

An example of this problem arises in developing totally

separate quantitative variables for the portfolio revision

and portfolio evaluation stages; the problem exists here

because these two stages often occur at roughly the same

point in time in the minds of the portfolio managers. When a

portfolio manager decides that portfolio objectives are not

met, his first response might well be to change the portfolio.

Therefore, there is difficulty in specifically defining the

point in time (and/or decision-making) where portfolio

evaluation and revision begin and end. As a matter of

convention, arithmetic means of portfolio characteristics

are defined as portfolio revision variables, and intertemporal

44

standard deviations around these means are defined as

portfolio evaluation characteristics. The rationale is that

the means represent the average targets of the portfolio

managers regardless of whether the values were determined by

changes in market values or by conscious portfolio changes;

the variability measures indicate to what extent the

targets changed over time, i.e., whether the targets were

changed to better meet portfolio objectives. Other view-

points might have led to alternative definitions.

The average values over the time period are given for

various portfolio mix variables PR1 through PR9. These

variables have the same definitions as PS1 through PS9,

respectively, except that period means are used instead of

initial values. The two measures of the "popularity" and

the quality ("blue chips") are the percentage of common

stocks and equivalents invested in the then-current Vickers

"Favorite 50" (PR10) and stocks listed in the Dow Jones

Composite Average (PR11); again, these are directly comparable

to PS10 and PS11. Concentration again appears as PR12 and

PR13; these are analogous to PS12 and PS13. One important

measure of the intensity of portfolio revision is annual

26 portfolio turnover, PR14.

Of?

The relationship between performance and portfolio size is analyzed in: Friend, et. al., pp. 61, 159; and Frank L. Voorheis, "Bank Trustees and Pension Fund Performance,' Financial Analysts Journal, 28 (July, 1972), 62-64.

45

Portfolio Evaluation.—As discussed in the preceding

section, the primary quantitative measures of portfolio

evaluation are the intertemporal standard deviations of

27

certain portfolio revision measures. PE1 through PE14

are the intertemporal standard deviations around the means

for PR1 through PR14, respectively.

As the portfolio evaluation continues to compare actual

performance to desired performance, reference must be made

continually to the planning variables—particularly those

over which control still remains. Therefore, the variability

around the mean values of the continuing planning (CP)

variables is an important element in decision-making. As a

result, portfolio evaluation variables PE15 through PE18

are the intertemporal standard deviations around CP1 through 28

CP4, respectively.

The more management spends on its efforts, the more

results should accrue; therefore, PE19 is the amount of °7 The actual intertemporal standard deviation is used

instead of the "unbiased estimate;" that is, all of the standard deviations used in this part of research have had the "sum of squared deviations" divided by "n" not "n-1". The actual standard deviation is used because it was the actual variation during the period; this part of the research is not using the standard deviation for statistical hypothesis testing, a use for which the "unbiased estimate" would be preferable; see J. Peter Williamson, Investments: New Analytic Techniques (New York, 1970), pp. 262-3.

2 8 The impact of these income requirements on subsequent

portfolio decisions is discussed in Sauvain, op. cit.

46

29

management fees and expenses. Portfolio management

controls these expenditures and can allocate more

(substantial PMP revision) or less (retain existing PMP).

As management views the current income position versus needs

to meet guaranteed dividend requirements as well as fees and

expenses, the excess of current return over the minimum

required income yield (including fees and expenses) is defined

as PE20. PE21 is the average annual turnover; turnover is a

function of how well management perceives that portfolio

objectives are being met. The fact that turnover appears as

both a portfolio revision and evaluation measure (PR14 and

PE21, respectively) is indicative of the definitional

difficulties inherent with such a closely interrelated

decision process.

Regression Methodology.—Each variable defined above is

regressed individually against the measures of performance.

Each dual fund represents one observation so that there are

seven sets of data for regressing each portfolio character-

istic against performance. The variables are grouped

according to the respective stage of the PMP as defined in

Table IV. For each PMP stage, a best fit, multiple linear

regression relation is developed. Finally, a best fit,

multiple linear regression equation is developed relating

performance to the best set of portfolio characteristics;

29 The relationship between performance and expenses is

analyzed in Friend, et. al., op. cit., pp. 61-62, 158.

47

this analysis should provide substantial insight into the

30

determinants of performance in the dual-fund industry.

All variable values are tabulated in Appendix B.

Portfolio Ch ar ac t er is t i c Lines

Portfolio theory indicates that each portfolio should

have a linear relationship between portfolio returns, ,

31 and market returns, Rm , , in the following form:

Hi j X R - A +B (R , ) + u, where: R, = portfolio return in z m , t z z period "t"

A = intercept of the characteristic line

3 = slope of the characteristic line

30 The regression model is used because of the assumed

relationship between performance and the portfolio characteristics. The research hypothesis states that performance is determined by the portfolio management process; the variables defined above are representative of managerial actions in each stage of the PMP. The com-parison of the assumptions of the regression model versus those of the correlation analysis model are discussed in Charles T. Clark and Lawrence L. Schkade, Statistical Methods for Business Decisions (Cincinnati, Ohio, 1969), p. 558.

31 The portfolio characteristic line is used in numerous

portfolio research efforts. For example, see: Michael C. Jensen, "The Performance of Mutual Funds in the Period 1945-1964," Journal of Finance, 23 (May,.1968), 389-410; and Jack L. Treynor, "How.to Rate Management of Investment Funds," Harvard Business Review,45 (January, 1965), 63-75. An alternative to the portfolio characteristic line as defined in this research is the mean-absolute-deviation line; however, "gains to be derived by obtaining characteristic lines with mean-absolute-deviation regression instead of least-squares regression may be relatively modest," William F. Sharpe, "Mean-Absolute-Deviation Characteristic Lines for Securities and Portfolios," Management Science. 18 (October, 1971), B-12.

48

R + = market yield in m' " period "t"

u = error term with zero mean

The slope, B, is equivalent to the 3 or volatility of the

portfolio returns. The intercept, A, equals:

A = a + (1 - 3) R„ where a = intercept of linear regression line of excess portfolio yield (R^-R^) regressed on excess market yield (R ,-R„)

111) t X R.f = risk-free market yield

3 = volatility of portfolio returns

The quarter-by-quarter gross portfolio returns for each

dual fund are regressed against the quarter-by-quarter

market returns for both the Dow Jones Industrial Average as

well as the Standard and Poor's 500 Index. Market returns

include both capital gains (or losses) and the equivalent

dividends indicated by the respective source. The regression

coefficients, A and B as well as a and 3, are determined for

each dual fund for the time period from inception through

1973.32

Coefficient of Determination for Portfolio Character-

istic Line.—The closer the actual performance fits the

regression curves, the more efficient is the portfolio.

2

Therefore, the coefficient of determination (r )-—the ratio

32 Both Modigliani and Pogue, op. cit., (May, 1974), 73,

and Jensen, oj>. cit. , 344, indicate that" a positive a is indicative of portfolio management performing better than random selection.

49

of variation explained by the regression equation to the total

variation—is a measure of how efficient, i.e., how well

33

diversified, is the portfolio. If the portfolio is, in fact,

inefficient, than the volatility of returns is not an appropriate

measure of risk. In a previous section on portfolio perfor-

mance, variability of returns—not volatility—is used as a

risk measure; the analysis of the coefficient of determination

is made to estimate the efficiency of the portfolio.

Non-linearity of Portfolio Characteristic Line.—Another

factor about the characteristic line is whether or not the

portfolio return/market return relationship is linear. The

quarter-by-quarter gross returns for each dual fund are

regressed against quarter-by-quarter returns from the

Standard & Poor's 500 Index to form the following parabolic

equation: 2

R = A+B(R ,) + C(R ) where R. = portfolio return in t m,t m,t T. perioci ut.t

R , = market yield in m' " period "t"

A, B, C = regression coefficients

This form is similar to the linear form except for the

2 addition of the second order term, C(R .)". If the

01 j t coefficient, C, is greater than zero, the parabola is concave

3^Modligiani and Pogue, op. cit., (March, 1974), 75 refer to: "A well diversified-portfolio will have a much higher r2(Q.85-0.95)." Treynor, op. cit., 66, says: "4 out of 5 [American mutual funds] demonstrate fairly clear-cut characteristic line patterns with correlation coefficients [r] equal to or exceeding 90%".

50

up and management would be illustrating the ability to

predict successfully market movements. If C is less than

zero, the parabola is concave down and management is

unsuccessfully predicting market trends. If C equals zero,

then the equation is linear and management has no market

predictive ability.

Buy-and-Hold Strategy versus Actual Performance

One way of analyzing performance is to compare actual

performance to what would have happened had management

simply held on to the original list of securities. In

this phase of the research, actual gross arithmetic returns

for each dual fund will be compared to the gross arithmetic

returns that would have occurred if the December 31, 1967,

portfolio for each dual fund was held without change

through December 31, 1973. Since each dual fund had its

own unique inception date in 1967, a common initial date had

to be selected so that each dual fund could be compared

over an identical time period. On December 31, 1967, each

dual fund had been in existence for at least 5 months and

the initial portfolio selection had been completed; there-

fore, December 31, 1967, is the initial date used for the

period under analysis.

34 Malkiel indicates that only about 50% of the portfolios

studied out-performed a buy-and-hold strategy, Burton G. Malkiel, A Random Walk Down Wall Street (New York, 1973), p. 154. A somewhat different conclusion—pro-portfolio management—is reported in James H. Lorie and Mary T. Hamilton, The Stock Market: Theories and Evidence (Homewood, 111. 1973), p. 134. '

51

The market price of each security held by a dual-fund

on December 31, 1967, is compared to the market price of

equivalent securities as of December 31, 1973; all stock

splits, stock dividends, conversions, and mergers are included

to determine the equivalent period-ending securities. All

common stock dividends are credited on an annual basis. All

cash and marketable securities held in the portfolio on

December 31, 1967, are assumed to be reinvested at the

following mid-year average of 90-day, U.S. Treasury bills:

Mid-Year average of 90-day Year Treasury Bills^

1968 5.3% 1969 6.8% 1970 6.5% 1971 4.8% 1972 4.1% 1973 8.0%

The average annual arithmetic return for each dual fund is

calculated by the formula:

Average (MP. -MP. fi7) + / T = 73 \ + T-bill Arithmetic = 1'4 1' „ / n l r . \ /interest \

Mean i^^D/^i,t^ J |on cash & I

\ , _ , Q J \marketable/ \ t = 68 securities 6 years

where: MP^ gr, = Market Price of security "i" on 12/31/67.

MP. r-7 = Market Price of securities eauivalent 1 , 0 to security "i" on 12/31/73. "

D/I. . = Dividend/Interest paid on security "i" ' in year "t", t = 1968 through 1973.

35 1975 Historical Chart Book, op. cit.

52

The actual versus the calculated returns are compared

before management fees and expenses. These gross returns

are then converted into net returns (of fees and expenses)

to determine if the efforts (resources) expended in portfolio

revision were worthwhile. Implicit in this analysis is

that the objectives of the firm as reflected in the

acceptance of risk remained constant over the time period

for each dual fund.

Qualitative Research Methodology

The primary purpose of the qualitative research is to

add depth to the quantitative research. Many factors are

not amenable to quantification but this fact alone does not

36

mean that such factors should be ignored. As discussed

earlier, performance can be viewed as comparing the

objectives of each dual fund as opposed to the actual

results; the qualitative analysis is much more useful for

this type of performance appraisal. As such, two qualitative

efforts are included in this research: (1) an analysis of

the written material presented by the portfolio managers

and corporate officers in each public report; and (2) a

survey of the portfolio managers and corporate officers of

each dual fund.

36 For a good discussion for dealing with factors not

readily amenable to quantification, see: Richard Ruggles, "Methodological Developments," in A Survey of Contemporary Economics, II, B. F. Haley, Ed. (Homewood, Illinois, 1953) 427-8.

53

Public Report Review.—Each public report for every

dual fund from inception through 1973 is reviewed and the

applicable comments of officers and/or portfolio managers

are discussed. The initial public document under

review is the initial prospectus available before each dual

fund went public. These initial prospectuses are partic-

ularly useful for the analysis of the portfolio planning stage

of the PMP.

The subsequent public reports that are analyzed are

the quarterly reports submitted to shareholders. The

initial quarterly report provides some insight into the

portfolio selection stage of the PMP while all subsequent

quarterly reports present information about the portfolio

revision stage. These reports also indicate whether the

portfolio management is satisfied with portfolio performance

(retains process) or dissatisfied (changes PMP); hence an

analysis of these reports provides insight into the

portfolio evaluation. These reports carry only infrequent

reference to the investment analysis stage, but do provide

extremely useful information about the remainder of the

portfolio management process used by each dual fund.

The review of the periodic reports also permits a

degree of dynamic analysis not possible in the quantitative

study. A comparison of management comments about market

trends can, in retrospect, provide knowledge of expectations

versus eventual outcomes. Information such as this is

54

simply not available in a quantitative form.

Portfolio Management Survey.—To provide additional

information about the PMP used by each firm, a questionnaire

was developed (see Appendix C). This questionnaire was sent

to a total of thirty-eight (38) past managers and corporate

officers of the various dual funds. For each dual fund, a

questionnaire was sent to the initial dual"fund president,

one or more of the remaining initial officers, as well as

each portfolio manager indicated in the quarterly reports


Since the questionnaire is designed to obtain •

information not available from public reports or reference

sources, questions are asked about such items as portfolio

strategy, research, organization structure and decision

37

making processes, control process , etc."" Questions #1 through

#8 deal with the portfolio planning stage of the PMP (a)

sample questionnaire is given in Appendix C). Information was

sought asking why a specific size or preferred dividend

structure was selected. Question #4 deals with concerns

over the initial marketing of the fund. Questions #5 and #6

37 Although the questionnaire was designed to parallel

the Portfolio Management Process (PMP), many of the questions were developed from discussions in three articles: Mark J. Appleman, "The Three Minds of the Professional Investor," Financial Analysts Journal, 29 (.September, 1973), 53-7; Edmund A. Mennis, "An Integrated Approach to Portfolio Management," Financial Analysts Journal, '30 (March, 1974), 38-46; William J. Crerend and Edward Broom, "A Taxonomy of Money Management," Financial Analysts Journal, 30 (May, 1974), 25-30.

55

38

seek information on initial portfolio strategy;

questions #7 and #8 deal with the initial planning period.

The second stage of the PMP--investment analysis—is

dealt with in questions #9 through #17. The percentage

of internal versus external research is asked for in

question #9 while #10 asks whether internal research

specializes or is "across-the-board" in terms of industries,

companies, etc. Question #11 asks whether internal research "5Q

develops "BUY, HOLD, SELL" lists; 53 Question #12 asks for

the percentage breakout of research as fundamental or

technical. Question #13 asks whether the internal research

capability includes an economist who generates macro-economic

40 forecasts. Question #14 asks whether explicit interest rate forecasts are made—a fact very important for funds

who have promised specific income generation.^ Question

#15 asks about market projections; #16 concerns the

generation of SELL recommendations—an alleged shortcoming

42 of much institutional research. JL The role of the portfolio

OO Mennis, o£. cit., discusses the role of setting

portfolio objectives on 42, 45.

39 Mennis, op. cit., questions the value of "guidance

or buy lists" on 45. 40 Mennis, o£. cit., states that "economic projections

are the foundation of any effective investment management process," 38.

4 1 Ibid. , 39.

42 Crerend and Broom, op. cit., point out the problems of

a lack of "SELL" discipline," 57 -

56

manager in generating research is discussed in #17.

Question #18 is an open-ended question meant to provide

inputs about the organizational structure for decision-

43

making; this question obviously deals with all stages

of the portfolio management process.

Information about the portfolio selection and revision

stages is sought in questions #19 through #26. Portfolio 44

turnover guidelines are dealt with in #19. #20 asks about

how satisfied the portfolio manager was with the diversifi-

cation. Information concerning major mix decisions is

45 sought in #21. Questions #22 and #23 deal with the percentage of trade recommendations executed as well as the

46

thoroughness of recommendations. The source and changes

in major mix decisions are dealt with in #24 and #25

respectively. Question #26 tries to find an adequate

description of the cause of portfolio changes.

Portfolio evaluation matters are dealt with in

questions #27 through #33 and #38 through #40. Questions #38 43 Crerend and Broom, op. cit., define three different

organizational styles and the impact each has on the resultant portfolio management, 25-27.

44 Mennis, o£. cit., 46, considers a measure of

portfolio turnover an important part of portfolio evaluation. 45

Ibid., 43. 46 Questions 22 and 23 have 'direct parallels to questions

4 and 1, respectively, in Appleman's questionnaire, op. cit., 51-2.

57

through #40 deal with management fees—their control and

adequacy. The effectiveness of portfolio changes are sought

47 in questions #27 and #28. Question #29 asks whether

portfolio volatility (g) is calculated and used in decision

48

making. The frequency and standards used in performance

appraisal are sought in #30 and #31. #32 concerns changes

in portfolio strategy or policy.

The organizational form of the portfolio management

company is dealt with in questions #34 through #37.49

Question #34 deals with management replacement until fund

termination. The existence of formal, written policies

concerning various portfolio management areas is discussed

in #35. Question #36 discusses the number and composition

of employees per dual fund. Question #37 asks about

restrictions placed on portfolio managers in terms of the 50

number or size of portfolios managed. Questions #42

and #43 are open-ended questions seeking information about

the past, present, and future of the dual-fund industry in

particular and portfolio management in general. 47 Mennis, op. cit. , 46, discusses the need for

determining the effectiveness of portfolio changes. 48 Mennis, ibid., mentions portfolio volatility as an

important portfolio evaluation consideration. 49 Questions 34 through 37 deal with organizational

factors similar to those discussed by Crerend and Broom, ££• £it., 25-27.

50 The "professionalism" aspect is heavily emphasised

by Crerend and Broom, o£. cit., 27.

58

The information obtained from the portfolio management

survey will be used solely for providing insight as to the

portfolio management process (PMP) in each dual fund. The

purpose of this survey is to provide background information

on how the fund actually was managed—information that is

most difficult for an external analyst or researcher to

obtain. As a result of this objective, the information

obtained from the survey will not be subjected to any

statisical analysis.

Research Limitations

There are several limitations to the proposed research.

First, an in-depth analysis of the portfolio management

process precludes an evaluation of a large number of managed

portfolios; therefore, conclusions drawn from the study of

the portfolio management process in the dual-fund industry

may not be directly applicable to all managed portfolios.

Second, the quantitative measures of the results of each

stage of the portfolio management process are not fully

developed in a theoretical framework. The definitional

difficulties for variables unique to each portfolio

management stage are indicative of this problem; this is

discussed earlier in the chapter.

One other major problem is the one common to all

51

external analysts. Since the researcher was not present

51 Dietz, op. city, 267-8, discusses the difficulties

encountered by external analysis of portfolio operations.

59

during the actual portfolio decision making, any

description of the portfolio management process must

necessarily be incomplete. On the other hand, no single

researcher or participant could have been present in each

and every dual fund throughout the period. One of the

objectives of the portfolio manager questionnaire is to help

fill in this gap about what actually went on in the portfolio

52

decision-making process for each dual fund. The

behavioral aspects of portfolio decision making are the

major missing elements. Therefore, this research will not

attempt to cover the behavioral considerations of the

decision-making process in the dual-fund industry.

The objective of this research is to determine how

portfolio management effects portfolio performance. The

main instrument for isolating causal factors is the

multiple, linear regression model discussed previously.

Williamson points out the "role of common sense...in

interpreting the results of a multiple regression" and also

discusses the danger of multicolinearity between data in a 53

portfolio management study. These factors must be given

substantial consideration. 52 Even the questionnaire must be recognized as a less

than perfect instrument. For example, a respondent to Appleman's survey responded about portfolio managers: "My view is you (the researcher) are dealing with an individual who is highly sensitive and probably egotistical. As a result his answers, while ostensibly honest, are going to be sharply slahtied," Appleman, op/ cit. , 50.

53 Williamson, op. cit., 283.

60

The last limitation is the fact that the analysis of

the dual-fund industry lacks a dynamic viewpoint. No

quantitative study is made of changes in portfolio decisions

in one period and the impact on performance in subsequent

periods. There are two reasons for this. First, a true

dynamic analysis is computationally far more

difficult; there would always be the difficulty in

separating the effects of management-instituted changes

versus market-created changes. Second, one of the major

puiposes of the qualitative research into the periodic

reports is to instill a degree of dynamism into this research

that even a rigorous quantitative research might overlook.

The subsequent chapter, "Review of the Literature,"

will provide a theoretical framework for the research

proposed in this chapter as well as bring into perspective

the limitations discussed above.

CHAPTER III

REVIEW OF RELEVANT LITERATURE

Introduction

This chapter is broken into three major sections. The

first section discusses the basic environment with which

portfolio managers must interact—the securities market.

The emphasis of this section is to describe the efficient

market hypothesis as it applies to security markets in the

United States; included in this section is a discussion of

research j.nto the market efficiency. The second major

section is a review of portfolio management. This

section has two subsections: (1) discussion of the

theoretical and practical considerations of managing a

securities portfolio; and (2) a review of the literature

that leads up to and supports the portfolio management

process (PMP) described in Figure 2 and Table I. The last

section is a discussion of the published research and

literature on the dual-fund industry.

U.S. Capital Markets and Their Efficiency

The capital markets in the United States can be

classified as primary or secondary markets. Primary

markets are those where new securities are sold by issuing

organizations to investors; the sales are frequentlv

facilitated by financial intermediaries. Secondary markets

61

62

encompass the purchase and sale of existing securities.

Prices in the secondary markets are determined through some

variation of auction or dealer markets. Secondary markets

primarily provide access to and liquidity for existing

financial assets. Pricing in the primary markets is

accomplished by comparing the risks and returns—and, hence,

prices—of proposed financial assets with existing

securities; the function of the primary markets is to allow

capital-using organizations the opportunity of selling

additional securities and, thus, raising additional capital.1

Only in the primary market does new capital flow to

capital users such as business organizations. However,

the pricing of new securities depends on the pricing in the

secondary markets of comparable financial assets. Secondary

market prices should reflect appropriately the risks and

returns associated with the various underlying issuers of

financial assets if capital flows to capital users are to

be in accordance with the relative productivity of the

2

potential users. Therefore, if the capital markets are to

1 For a brief informative discussion of the role and

interactions of the securities markets and intermediaries, see Keith V. Smith, Portfolio Management (New York, 1971), pp.11-13.

2 That is, markets are efficient when "firms can make

production-investment decisions...under the assumption that security prices at any time fully reflect all available information." Both financial managers and investors are best able to make intelligent allocation/acquisition decisions in efficient securities markets. Eugene F. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, 25 (May, 1970), 383.

63

operate efficiently, the secondary market pricing mechanism

needs to be working efficiently.

Definitions of Market Efficiency

A secondary security market is efficient where:

a large number of buyers and sellers react through a sensitive and efficient mechanism to cause market prices to reflect fully and virtually instantaneously what is knowable about the prospects for the companies whose securities are being traded.^

Therefore, "current market prices of securities are always

equal to or almost nearly equal to the best estimate of the

true investment values."4 Although efficient markets have

been defined above, the concept of efficient markets is

actually a hypothesis subject to research and testing.

There are three forms of the efficient market

hypothesis (EMH):

The weak form asserts that current prices fully reflect the information implied by the historical sequence of prices...The semistrong form of the hypothesis ?,sserts that current prices fully reflect public knowledge about the underlying companies...The strong form asserts that not even those with privileged information can often make use of it to secure superior in-vestment results.5

3 James H. Lorie and Mary T. Hamilton, The Stock Market:

Theories and Evidence (Homewood, Illinois, 1973), p. WT. 4 Douglas A. Hayes and W. Scott Bauman, Investments:

Analysis and Analysis and Management, 3rd Ed. ("New York. 1976), p. 413. ~~

5 Lorie and Hamilton, op. cit. , p. 71.

64

The subsequent sections review the literature on each form

and then discuss the implications of the research on the EMH.

Test Results of the "Weak" Form of the Efficient Market Hypothesis • (EMH)

The weak form of the EMH is a "refinement and

generalization of the 'random walk hypothesis,'"6 that is,

prices of securities and changes in prices of securities tend

to follow a random pattern over time. The use of the term

"random walk" was somewhat unfortunate in that practitioners

in the securities industry felt that the academicians

espousing and testing the hypothesis were saying that the

industry's efforts were worthless. On the contrary, the

random walk hypothesis expresses the view that stock prices:

respond immediately to the continual flow of investment information... some of this information is both favorable and unfavorable; however, it is asserted that there is no particular pattern to it so that it's time sequence has a random effect on changes in stock prices.7

Numerous tests of the "random-walk" theory were performed

in the middle 1950's and early 1960's. The following

discussion illustrates some of the research.

ihe idea that market prices might follow a "random walk"

was discussed as early as 1900;** however, little was done

© Hayes and Bauman, o£. cit.

7 Ibid., p. 414.

Louis Bachelier in a x900 report "studied commodity prices and concluded that they follow a random walk, though he did not use the term." Lorie and Hamilton, o£. cit., p. 72.

65

with the concept until the 1950's. In 1953, Kendall studied

both British industrial common stock prices as well as

United States commodity prices; he suggests:

The series looks like a wandering one, almost as if once a week the Demon of Chance drew a random number from a symmetrical population of fixed dis-persion and added it to the current price to determine the next week's price.®

In 1959, two independent studies—one by Roberts and the other

by Osborne—led to greater efforts in developing and testing

random walk hypotheses. In Robert's study:

a series of numbers created by cumulating random numbers had the same visual appearance as a time series of stock prices...An observer... could detect the well-known head-and-shoulders formation and other patterns both in the series representing stock prices and in the random series.10

The second study was by a physicist, Osborne. Osborne "found

a very high degree of conformity between the movements of

11

stock prices and the law governing Brownian motion."

The two studies by Roberts and Osborne set off a wave of

research. Studies include Fama (1965) who studied serial

correlation and persistence of "runs" in time series of

stock prices and found no significant difference from a random

^Maurice G. Kendall, "The Analysis of Economic Time-Series, Part I: Prices," Journal of the Royal Statistical Society, (1953), 11-25, cited'by Fama, op. cit.,390.

10Lorie and Hamilton, oj>. cit„

11lbid.

66

12

price-generating mechanism. In 1970, Fama summarized the

results of six other studies and concluded that—although

there usually is a small, positive serial correlation between

price changes—"it is unlikely that the small absolute levels

of serial correlation... can be used as the basis of 13

substantially profitable trading systems." To refute the

random-walk hypothesis, Alexander tried to develop "trading

rules based solely on price changes which could produce 14

abnormally high rates of return." Later studies connecting

and extending the work of Alexander showed that "when

brokerage commissions are taken into account, these short-term

trading strategies failed to generate rates of return greater 15

than that of a buy-hold strategy."

The previously discussed research was useful but limited

by the fact that it consisted of "a large body of empirical 1 0

research in search of a rigorous theory.""1" Studies by

Samuelson (1965) and Mandlebrot (1966) first brought together

the implications of the random-walk hypothesis and the 12 Eugene F. Fama, "The Behavior of Stock Market Prices,"

Journal of Business, 38 (January, 1965). 34-1G5,~ cited in Lorie and Hamilton, o£. cit., pp. 75.

13 Fama, op. cit., 303-304.

14 Lorie and Hamilton, oj>. cit. , p. 77.

15 Hayes and Bauman/ oj). cit.

16Fama, op. cit., 359 .

67

17 specification of the efficient market hypothesis; in

particular, Samuelson proved that prices in efficient

18

markets fluctuate randomly. Sufficient conditions for a

market to be efficient include: (1) no transaction costs;

(2) all information costlessly available to all market

participants; and (3) all participants have the same 19

expectations about securities prices. In Fama's words, "In such a market, the current price of a security obviously

20

'fully reflects' all available information." Markets with

the above characteristics would generate randomly fluctuating

prices, but such markets are clearly unrealistic.

17 Ibid.

18 Lorie and Hamilton, op. cit,, p. 80. Technically:

In such...weakly efficient markets, the past price series of a security will contain no infor-mation not already impounded in the current price... such a market will follow a submartingale—that is, the expected value of all future prices

XCt — T}, {T=1,...,00} and is equal to

E[X{T + T} I X '{TJ, X<T-1}, X^T - 2} , . ' ]=E[;x{ t+T} I X^T

=f (X } x {t} ,

where f{t}is the "normal" accumulation rate.

Thus, in a market in which security prices behave as a submartingale of the (above) form, forecasting techniques which use only the sequence of past prices to forecast future prices are doomed to failure. The best forecast of future price is merely the present price plus the normal expected return over the period." Michael C. Jensen, "Risk, The Pricing of Capital Assets, and The Evaluation of Investment Portfolios," Journal of Business, 42, (Ap^il,- 1969), 168.

19 Fama, op. cit., 387.

20ibid.

68

Fama points out that necessary conditions for market

efficiency are far less restrictive: (1) information is

readily available to a "sufficient" number of investors;

(2) transaction costs are "reasonable," and (3) market

participants do not use available information to perform

21

consistently better or worse than average. Fama

concludes: But though transaction costs, information that

is not freely available to all investors, and disagreement among investors about the implications of given information are not necessarily sources of market inefficiency, they are potential sources. And all three exist to some extent in real world markets. Measuring effects on the process of price formation is, of course, the major goal of empirical work in this area.

The testing of these three factors represents the basis of

much of the "semi-strong" and "strong" forms of the

efficient market hypothesis discussed in the next sections.

The initial testing of the weak form of the EMH led to

misunderstanding and outright rejection by some members of

the financial community. First, efficiency does not mean

that some portfolio managers Cannot do above or below

average, only that consistent "winning" portfolio management

23

is extremely difficult. Secondly, the EMH is not

contradicted by the fact that stock prices appreciate over 21 22

Ibid, „ 387-8. Ibid.. , 388. 23 Robert R. Glauber, "Modern Investment Theory: It's

Implications for Competition Among Financial Institutions," New England Economic Review (May, 1974), 5.

69

24 time; all that this indicates is that "the distribution

25 of price changes has a nonzero mean."

Research Results of the "Semi-Strong" Form of the EMH

The semi-strong form of the EMH "claims that current

market prices properly reflect all relevant publicly disclosed

information, and, consequently, superior returns cannot be

earned by conventional or ordinary fundamental analysis of

26

this public information." A number of research studies into

the effects of publicly available information on stock prices

have been reported; information studied includes: stock

splits; corporate earning announcements; secondary stock

issues; and announcements of changes in Federal Reserve 27

discount rates.

Fama, Fisher, Jensen, and Roll (FFJR) studied the

impact of stock splits on stock prices and found that: 24 , . .

Ibid. , 5-6. 25 Lorie and Hamilton, 0£. cit., p. 81.

26„ , „ Hayes and Bauman, ojd. cxt., p. 414.

97 Ibid.. pp. 414-15.

70

Apparently the market makes unbiased forecasts of the implications of a split for future dividends, and these forecasts are fully discounted in the prices of the security by the end of the split month...FFJR conclude that their results lend considerable support to the conclusion that the stock market is efficient, at least with respect to its ability to adjust to the information implicit in a split.

Ball and Brown (1968) studied returns of stocks where

earnings were announced as either increased or decreased.

Stock prices apparently adjusted to the news in the year

prior to the earnings announcement leading Ball and Brown

to conclude: "no more than about ten to fifteen percent

of the information in the annual earnings announcement has

29

not been anticipated by the month of the announcement."

Scholes (1972) studied large offerings of secondary

issues of common stock. Stock prices fell somewhat when

the offering was made, but Scholes believed that the

decline was the result of the "negative information implicit

in the fact that somebody is trying to sell a large block 30

of a firm's stock."" Scholes suggests that the value of the

28 Eugene F. Fama, Lawrence Fisher, Michael Jensen, and

Richard Roll, "The Adjustment of Stock Prices to New Information," International Economic Review, x (February, 1969), pp. 1-21, cited in Fama, o£. cit. , 408,

OQ Ray Ball and Philip Brown, "An Empirical Evaluation

of Accounting Income Number," Journal of Accounting Research, 6 (Autumn, 1968), 175, cited in Fama, op. cit.

30 Myron S. Scholes, "The Market for Securities:

Substitution versus Price Pressure and the Effects of Information on Share Prices," Journal of Business, 45 (April, 1972), 179-211, cited in Fama, op. cit., 409.

71

information depends on who is selling the stock; when the

corporation or its officers are selling the stock, this

31

information has the greatest negative impact.

Evidence indicating that the securities markets were not

perfectly efficient also exists.. Waud (1970) found a small

but statistically significant effect for the stock returns

on the day following changes in the discount rate at Federal

32

Reserve Banks. Kisor and Messner (1969) studied

securities with an accelerating growth rate in earnings;

they found that prices of such securities out-performed 33

the S&P 425 index. This research and a study by Latane

and Tuttle "tend to support the notion that the market does

not immediately and fully adjust to new fundamental

information, rather the prices in the market may take a period 34

of several months to adjust." 31t, . ,

Ibid. 32 Roger N. Waud, "Public Interpretation of Discount Rate

Changes: Evidence on the 'Announcement Effect,'" Econometrica, 38 (April,. 1970), '231-50; cited in Lorie and Hamilton, op. cit., p. 87.

33 Manown Kisor, Jr. and Van A. Messner, "The Filter

Approach and Earnings Forecast," Financial Analysts Journal, 25 (January, 1969), 109-15.

34 Henry A. Latane and Donald L. Tuttle, Security

Analysis and Portfolio Management CNew York, 1970), pp. 538-40, cited in Hayes and Bauman, o£. cit., p. 415.

72

Concluding this section on the semi-strong form of the

EMH, Fama's comments succinctly summarize the evidence:

In short, the available semi-strong form evidence on the effect of various sorts of public announcements on common stock returns is all consistent with the efficient market model. The strong point of the evidence, however, is its con-sistency rather than its quantity; in fact, few different types of public information have been examined, though those treated are among the obviously most important.35

Research Results of the "Strong" Form of the EMH

The strong form of the EMH states that "prices reflect

not only what is generally known through public announcements

but also what is not generally known."36 The tests of the

strong form of the EMH include analyses of the performance

of professionally managed portfolios as well as certain

other sophisticated and/or knowledgeable investors. The

following discussion will cover four (4) studies of mutual

fund performance and three (3) research studies on other,

sophisticated and knowledgeable investors.

The first study considered here was performed by

Sharpe (1966) on the performance of 34 mutual funds; Sharpe

considered not only the returns from the mutual funds but

also a measure of risk—the standard deviation of returns,

or the variability of returns. Sharpe found that 19 out

of thirty-four outperformed the Dow Jones Industrial Average

35 Fama, op. ext.

36 Lorie and Hamilton, op. cit., p. 88.

73

(DJIA), ignoring expenses; when expenses are included, only

37

11 mutual funds outperformed the DJIA. Sharpe used the

excess return to variability, $, as. his performance

measure (see Chapter II). Sharpe concludes that: there are differences among funds; and such differences do not appear to be entirely transitory. To a major extent they can be explained by differences in expense ratios, lending support to the view that the capital market is highly efficient and that good managers concentrate on evaluating risk and providing diversification, spending little effort (and money) on the search for un-correctly priced securities.38

The next mutual fund research under review here is by

Jensen (1968-1969). Jensen analyzed 115 mutual funds for

39

the 1955-64 time period. He compared returns of mutual

funds to what would have resulted from equally risky,

randomly selected portfolios; Jensen used volatility (3)—

or sensitivity of the portfolio's return to changes in

market returns—as his risk measure. He found 43 out of 115

outperformed equally risky, randomly selected portfolios.

That is, on average, the mutual funds did not outperform

the market; further analysis failed to find any individual

37 William F. Sharpe, "Mutual Fund Performance," Journal

of Business, 39 (January, 1966), 119-38. q o

Ibid. , 137-8.

49 Michael C. Jensen, "Risk, the Pricing of Capital

Assets, and the Evaluation of Investment Portfolios," Journal of Business, 42 (April, 1969), 167-247. An earlier study by the same author reflected a similar frame-work, "The Performance of Mutual Funds in the Period 1945-64," Journal of Finance, 23 (May, 1968), 389-416.

74

mutual fund that consistently outperformed randomly

selected portfolios.40 Jensen, like Sharpe, found that

portfolio returns were negatively correlated with portfolio

expenses,41 thus, adding support to the EMH.

Friend, Blume and Crockett studied 136 mutual funds

42

through most of the 1960's. The results of their research

are not easy to summarize due to the many ways that

performance was compared for both the entire time period

as well as sub-periods. In general, the funds have not matched the

performance of the unweighted portfolio of NYSE stocks during the 1960-9 period. But they have matched the performance of the (market value) weighted portfolio...The performance analysis gave no indication that higher sales charges, management costs or trading expenses are consis-tently linked with performance either above or below that of random portfolios.43

The last mutual fund study discussed here is by

Williamson (1972) who studied 180 mutual funds for the

1961-70 time period;44 Williamson states: "the results

40Jensen, "The Performance of Mutual Funds," op. cit., 220-242.

41Ibid., 243.' . A 2

Irwin Friend, Marshall Blume, and Jean Crockett, Mutual Funds and Other Institutional Investors (New York, 1970).

4*5 Ibid., pp. 22-34.

44 Peter J. Williamson, "Measurement and Forecasting

of Mutual Fund Performance," Financial Analysts Journal, 28 (November, 1972), 78-84.

75

suggested that all portfolio managers are equal in their

ability to 'beat the market.' The only differences among

45 the funds lie in volatilities." On the other hand,

Williamson suggests:

the same set of 180 mutual funds provided evidence that at least a few funds are con-sistently out—performing most other funds. There was evidence that some funds are con-sistently in the top 40 percent of the entire group, although there seems to be no evidence that any funds are consistently in the bottom 40 percent.

The studies and results discussed above are not the only

research on mutual funds. Because of the visibility of

mutual fund portfolio managers, the mutual fund performance

has been well studied and the results of other research

47 are comparable.

Several other studies have been reported on the

possible performance of groups of investors who have or

can generate special information. Niederhoffer and Osborne

45Ibid., 80-92. 46Ibld., 82.

"^Examples of other mutual fund research are: Irwin Friend, et. _al., A Study of Mutual Funds, Wharton School of Finance and Commerce, University of Pennsylvania, 1962; Irwin Friend and Douglas Vickers, "Portfolio Selection and Investment Performance," Journal of Finance, 20 (September, 1965), 391-413; Frank E. Block, "Risk and Performance," Financial Analysts Journal, 22 (March, 1969), 66-74; W~ Scott Bauman, ""Evaluation of Prospective Investment Periormance." Journal of Finance, 2§ (May, 1968), 276-95; John C. Bogle, "Mutual Fund Performance Evaluation," Financial Analysts Journal, 26 (November, 1970), 25-33+.

76

(1966) studied specialists trading on the major exchanges;

they conclude "specialists on the N.Y.S.E. apparently use

their monopolistic access to information concerning...limit

48 orders to generate monopoly profits." Lorie and Niederhoffer

analyzed insider trades from 1950 through 1960 and found:

proper and prompt analysis of data on insider trading can be profitable... When insiders accumulate a stock intensively, the stock can be expected to outperform the market during the next six months. Insiders tend to buy more often than usual before large price increases and to more often than usual before price decreases.

The last research presented here deals with the

generation of potentially profitable information. In perfectly

efficient markets, neither publicly nor privately

available information could be used to generate superior

returns. Black (1973) analyzed the Value Line ranking

system for 1965-72:

48 Fama, op. cit., 413-414, summarizing the results

of Victor Niederhoffer and M.F.M. Osborne, "Market Making and Reversal on the Stock Exchange," Journal of the American Statistical Association, 61 (December, 1966), 897-916.

49 Lorie and Hamilton, oj). ext., p. 96 quoting James

Lorie and Victor Niederhoffer, "Predictive and Statistical Properties of Insider Trading," Journal of Law and Economics, 11 (1968), 35-53. Also see:' Myron S. Scholes, "The Market for Securities: Substitution versus Price Pressures and the Effects of Information on Share Prices," Journal of Business, 45 (April, 1972), 179-211.

77

After taking transaction costs and risk into account, the performance of the five portfolios (one portfolio for each Value Line rank) were consistent with their rankings; that is, the group ranked ©ne had the highest return and group five had the lowest return.50

In summary, the research of the strong form of the

EMH yields some contradictory results. The results are

weakened even more by the fact that most research

supportive of the strong form of the EMH comes from analysis

of only one sector of portfolio managers—those managing

51

investment companies. The next section deals with the

implications of the EMH and the associated research on a

portfolio management.

Implications of the EMH

The previous sections present evidence concerning the

validity of the efficient market hypothesis. The evidence

is contradictory in that there are research results that

50 Hayes and Bauman, op. cit., p. 417, summarizing:

Fischer Black, "Yes Virginia, There is Hope: Tests of the Value Line Rank System," Financial Analysts Journal, 29 (September, 1973), 10-14.

51 There are, of course, research results from other areas

of portfolio management; for example see: Peter 0. Dietz, "Measuring Pension Fund Performance," Financial Executive, Vol. 37 (November, 1969), pp. 20-34; and Gary G. Schlarbaum, "The Investment Performance of the Common Stock Portfolios of Property Liability Insurance Companies," Journal of Financial and Quantitative Analysis, 9 (January, 1974), 8"y-yb. Ehrbar "reports a brokerage firm, Becker Securities, has comparable data for 3000 pension funds; the results indicate "the managers underperformed the market by more than one would have expected from their risk levels alone;" see A. F. Ehrbar, "Index Funds—An Idea Whose Time is Coming," Fortune, 93 (June, 1976), 146-7.

78

indicate that information exists from which portfolio

decisions could be derived; however, there is little

evidence that professional portfolio managers—primarily

those of investment companies—ever accomplish consistently

superior performance. The efficient market hypothesis and

the evidence create an interesting paradox:

In order for the hypothesis to be time, it is necessary for many investors to disbelieve it. That is, market prices will promptly and fully reflect what is knowable about the companies whose shares are traded only if investors seek to earn superior returns, make conscientious and competent efforts to learn about the companies whose securities are traded, and analyze relevant information promptly and perceptively. If that effort were abandoned, the efficiency of the market would diminish rapidly.52

In analyzing the implications of the EMH on portfolio

management, the portfolio management process (PMP) is used

as a framework of discussion (see Figure 2 and Table I).

The impact of the EMH on the five PMP stages—portfolio

planning, investment analysis, portfolio selection,

portfolio revision, and portfolio evaluation—are discussed

below.

Portfolio planning is extremely important in efficient

markets. Here the needs and resources of the investor

are analyzed and an appropriate investment policy—

appropriate in terms of risk/return, timing, taxes, etc.—

is developed and specified. "Those who have found the

5O ' "Lorie and Hamilton, op. cit., p. 98.

79

evidence regarding the efficiency of markets convincing,

as have the authors iLorie and Hamilton 1...will believe

that the most important decision—the one with the greatest

impact on results—is the choice of policy with respect to

risk."53 If the markets are quite efficient, then the

basic difference between rates of return arises from

different levels of risk accepted. The portfolio planning

stage is the PMP area where the policy toward risk acceptance

is made; and thus, this stage becomes extremely important

in terms of the subsequent returns. In spite of the

importance of portfolio planning, the investment policy

derived from it suffers from the "ambiguity and vagueness

54

of its [investment policy! expression." Important though

investment policy may be, these deficiencies 'ambiguity

and vagueness] are often so pronounced that the policy

neither provides meaningful guidance to the portfolio

manager nor the effective means for controlling him and 55

evaluating his performance.

The next PMP stage is investment analysis and includes

security analysis leading to a reduced set of potential

investments for the specific portfolio. Lorie and Hamilton

5°Ibid., p. 260

^Ibid. , p. 264.

55ibid.

80

suggest:

The most general implication of the efficient market hypothesis is that most security analysis is logically incomplete and valueless... The logical incompleteness consists in failing to determine or even consider whether the price of the Stock already reflects the substance of the analysis. "

Even such a strong statement should not be interpreted to

mean that EMH advocates believe security analysis is worthless;

however, "the proponents of-EMH.do not deny the need for

security analysis except that, like thrift, it is some-

57 thing one encourages others to practice."

Bourdeaux views security analysis and market efficiency

from a "production function" standpoint and states :

There is a positive relationship between the amount of resources devoted to security analysis and the resulting level of market efficiency: when large amounts of effort are expended on security analysis, market efficiency is high; (and conversely)...at low levels of security analysis, increases in market efficiency for each increase in security analytical effort are large. But as more and more resources are used this way and prices reflect available information more and more quickly, the increases in market efficiency become smaller and smaller until additional levels of security analysis result in no further increase.58

Figure 4 illustrates this point. With over 10,000 registered

financial analysts and many times that number of market

Ibid., p. 100.

57 Leopold A. Bernstein, "In Defense of Fundamental

Investment Analysis," Financial Analysts Journal, 31 (January, 1975), 57.

CO

Kenneth J. Bourdeaux, "Competitive Rates, Market Efficiency, and the Economics of Security Analysis," Financial Analysts Journal, 31 (March,'1975), 18.

81

o Ci CD •H O •H 4-i "4-j w 4J

<u

to a

Small Increases in Market Efficiency for Large Increases in Resources Used in Analysis

Perfect Market Efficiency

Large Increases in Market Efficiency for Small Increases in Resources Used in Security Analysis

Resources Used in Security Analysis

Figure 4. The Relationship Between Market Efficiency and the Resources Used in Security

Source: Kenneth J. Bourdeaux, "Competitive Rates, Market Efficiency, and the Economics of Security Analysis," Financial Analysts Journal, Vol. 31 (March, 1975), pp. 18-22.

32

participants who analyze securities, one must wonder at

what point does the current market efficiency lie along this

curve (see Figure 4); that is, how much incremental benefit

per incremental cost can be generated through additional

security analysis given the current state of market efficiency?

In summary, security analysis for an individual portfolio

probably creates little value; however, the work of all

analysts together creates a substantial value—market

efficiency. Similarly, another important output of the

investment analysis stage is the list of acceptable securities.

Since "there is remarkably little evidence that 'buy lists'

59

outperform other securities of similar risk," the

question remains whether investment analysis provides much

value for an individual portfolio.

The subsequent PMP stages are portfolio selection and

portfolio revision. In markets that are efficient, the

initial portfolio selection should select a portfolio with an

appropriate degree of diversification and the appropriate 0 0

level of risk (hence, the desired return). Portfolio

revision should insure that the appropriate portfolio risk is

maintained, that transactions are made after consideration

of the investors' tax position, and that transaction costs are 59 Lorie and Hamilton, op. cit., p. 265.

6 0 -Jensen, oj). cit. , 243-4; and Lorie and Hamilton,

op. cit., pp. 107-9.

83

01

minimized.

The last PMP stage—portfolio evaluation—is closely

related because it includes the measurement and evaluation

of portfolio risk/return and the minimization of management

fees and expenses. In efficient markets, portfolio

evaluation would center around determining both absolute and

relative measures of risk and return and comparing these

values to those established in the portfolio planning stage.

However, the policies and/or values generated at that initial

point suffer from "vagueness and ambiguity;" therefore, the

value of comparing actual versus proposed suffers to the

extent that the original objective was poorly formulated

(see above discussion on portfolio planning). Last, the

portfolio evaluation should ensure that every portfolio

dollar converted into something other than earning assets

was well spent. The questions include: were transaction

costs minimized; were the number of transactions kept at an

appropriate level; and were those dollars spent on

obtaining portfolio management services well spent?

Portfolio Management

This section is broken into three subareas. These

areas cover the theoretical background of portfolio

theory, the practical aspects of managing a portfolio of

financial assets, and a background behind the development

SI Lorie and Hamilton, op. cit., p. 109.

84

and use of the portfolio management process (PMP) model

used as an analytical framework in this research. The

capital asset pricing model (CAPM) is discussed

briefly in the portfolio theory section.

Portfolio Theory

Modern portfolio theory rests heavily on the contribution

of Markowitz. In fact, the terms portfolio theory and

Markowitz theory "are for all practical purposes,

62

synonymous." Markowitz points out that a portfolio has

both risk and return as characteristics; and the risk of

the portfolio as a whole is a function of the riskiness of

the component securities as well as the interrelationship

of returns between the component securities.63 Hence, the

return of a portfolio could be expressed as follows:

N R = E X. E where: R = return on portfolio "p"

j=l J J p

X. = proportion of portfolio invested in security "i"

= return on security "j"

62 William F. Sharpe, Portfolio Theory and Capital Markets

(New York, 1970), p. 3. Sharpe's book is an excellent text for those unfamiliar with the concepts of portfolio theory.

0 3 For a complete discussion of Markowitz's theories,

see Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investments (New York, 1959).

85

and the riskiness of the portfolio could be defined as some

measure of variability of return such as standard deviation

64 or variance (defined below):

2 N N S = I X X X.S.S.C. . P i-1 j=l i J 1 J

2 where: S = variance of portfolio "p"

P

Xn = proportion of portfolio invested in security "i" or "j"

Sn = standard deviation of security "i" or "j"

C. . = correlation coefficient of security "i" ' J with security "j"

In addition, Markowitz pointed out that some portfolios

are superior to other portfolios in that for the same level

of return, one portfolio may have less risk. Also, for a

given level of risk, one portfolio may have a higher return.

This dominance of one por-tfolio over another results in the

definition of efficient portfolios, i.e., those that have

"(1) highest expected return for a given level of risk and

64 Since the covariance between two securities. COV.., is

equal to S.S.C. the above equation for could be expressed as? J P

2 = N N P z z x.x.cov. .

i-1. 3=1 1 J

The above equations have been expressed in an expectational form; if past data is being described, the following substitutions would better conform to standard notation: 0p ^Sp)' Gi^Si^'pi3^Cijyj^Ej)" T h e s t a n d a r d deviation, Sp

is simply the square root of the variance, S|j.

86

(2) lowest level of risk for a given level of expected

65

return." Figure 5 shows an example of a hypothetical

efficient frontier; i.e., given the state of the capital

markets, what sets of financial assets represent the best

possible risk/return combinations. Although points ABCD

represent the edge of the set of possibilities, some

portfolio between B and C actually dominates portfolio

D because it has less risk for the same return.

Given the possible portfolios obtainable in the

existing capital markets, the question remains: which is

the one best efficient portfolio for an investor to hold?

To answer this, reference must be made to the utility

function of the investor. That is: A utility function is the relationship between wealth and utility. Since money, like other things, has diminishing marginal utility... (the) utility function is the relationship between wealth andutility... (the) utility increases at a decreasing rate as wealth increases. 6*3

65 Smith, Portfolio Management, op. cit., p. 71.

66 Lorie and Hamilton, op. cit., p. 192. The utility

function is generally characterized as quadratic which indicates that the expected utility is a function of the mean and variance of the probability distribution of future returns. In a general form, U(R

D) = f(R > S ). There are

other alternatives, for example, see ClaptonpP. Alderfer and Harold Bierman, Jr., "Choice with Risk: Beyond the Mean and Variance," Journal of Business, 43 (July, 197Q), 341-53. For a more complete discussion of efficient frontiers and families of indifference curves, see Lorie and Hamilton, o£. ext., pp. 183-97.

87

Return

Non-feasible Portfolios

Feasible Portfolios

Risk

Figure 5 . Hypothetical Efficient Frontier for Capital, Markets

Adapted fran:' James H. Lorie and Mary T. Hamilton, The Stock Market: .Theories and Evidence(Hanewood, Illinois, WTTTT p.ttj;

88

Each investor has a family of utility functions; at

all points along any given utility function, the investor

is indifferent between the assumed combinations of return

and risk.

With this framework, portfolio theory describes

portfolio management as consisting of three tasks:

1. Security analysis (predicting rates of return of individual securities).

2. Portfolio analysis (determining a portfolio's future return and risk possibilities).

3. Portfolio selection (selecting from among those portfolios deemed worthy of further consideration in stage two that single portfolio most suitable for the owner's particular p u r p o s e ) . ^

As noted previously, security analysis in efficient markets

may be of questionable marginal value. Therefore, portfolio

theory has centered around the mechanisms of determining

efficient portfolios and, then, selecting the one efficient

portfolio best suited for the investor. Figure 6 illustrates

this effort with an efficient frontier and an investor's

family of indifference curves; note that efficient portfolio

B can be extended into a whole series of portfolios

containing B and some combination of lending or borrowing at

the risk free interest rate, R^.

It is clear that any combination portfolio along the

line RfB dominates all portfolios on the efficient frontier

67 Jack Clark Francis and Stephen H. Archer, Portfolio

Analysis (Englewood Cliffs, N.J., 1971), p. 5. For a more intuitive description of the same tasks, see Sharpe, on cit Portfolio Theory , pp. 31-33. — '

89

Return

'R,

Higher Utility

Landing Eortfolios^

arrowing Portfolios

-Efficient Frontier

\

Feasible Portfolios

Risk

figure 6. Portfolio Theory Approach to Portfolio Analysis (generating efficient portfolios) and Portfolio Selection(selecting the efficient portfolio with ixiaximm utility to investor)

Note: Indifference curve I„ is preferable to I ; I9 is preferable to I , etc. 2

t - — r

90

itself; that is, the portfolios lying on the RfB line are

superior to those that could be constructed from risky

assets alone. The line RfB is referred to as "Sharp©1s

capital market line."68 The intercept, R f > is the risk

free rate of return; the risk premium for any given set

of financial assets along the capital market line is equal

to the price of risk times the standard deviation of the

returns of efficient portfolio, p. Mathematically:

EP " Rf + (Em - Rf ) V Sm

where: E = expected return for portfolio "p" IP Rf = risk free return

E = expected return for market m

S = standard deviation of return on the m market

= standard deviation for portfolio "p"

Hence, the return on an efficient portfolio is a linear

function of its risk as measured by the standard deviation

of the portfolio return. The slope of the linear

relationship is called the "price of risk;" this "price

of risk" indicates the additional expected return for each

additional unit of risk where risk is measured by the

standard deviation of market returns.

£*Q

For an excellent discussion of the development of the capital market line, see Sharpe, op. cit., Chapter 5, pp.77-103,

91

The total risk of a portfolio can be decomposed into

69

systematic and unsystematic risk. Systematic risk "is

the volatility of rates of return on portfolios associated 70

with changes in rates of return on the market as a whole."

The systematic risk is non-diversifiable, i.e., all common

stock portfolios have a systematic risk component regardless

of how well they are diversified. The unsystematic risk

represents that part of portfolio risk that is not explained

by changes in market returns; in theory, the unsystematic

risk can be eliminated through appropriate diversification, 71

i.e., "only inefficient portfolios have unsystematic risk."

The variability of the returns on any financial asset

compared to the variability of the market returns (i.e.,

Sp/Sm) is the sensitivity of rates of return on a portfolio

to the market as a whole (i.e., 0 or volatility). Therefore,

the above equation can be simplified to: E(Rp) =• Rf + (S<V-R f) Bp

The above equation was developed by Sharpe and referred to as

72 the capital market line. Note that under this formulation,

69 Within the framework of systematic and unsystematic

risk, there are many combinations of risk that are definable both intuitively and quantitatively. For an excellent presentation along these lines, see: Eugene F. Fama, "Components of Investment Performance," Journal of Finance, 27 (June 1972), 551-67.

70 Lorie and Hamilton, op. cit. , p. 275.

71Ibid., p. 276.

72 Sharpe., op. cit., pp. 38-86.

92

3 Is the relevant risk measure. Later discussion of this

relationship referred to the equation and its derivations

as the Capital Asset Pricing Model (CAPM); the CAPM

supposedly holds true for either individual or sets of

financial assets in efficient capital markets. The CAPM

has been subjected to rigorous testing and the results can

be summarized as follows:

1. The evidence shows a significant positive relationship between realized returns and systematic risk. However, the slope of the relationship is usually less than predicted by the CAPM.

2. The relationship between risk and return appears to be linear. The studies give no evidence of significant curvature in the risk/return relation-ship.

3. Tests that attempt to discriminate between the effects of systematic and unsystematic risk do not yield definitive results. Both kinds of risk appear to be positively related to security returns.73

The authors continue: "we cannot claim that the CAPM is

absolutely right. On the other hand, the empirical tests

.74

do support the view that beta (3) is a useful risk measure.'

The implications of CAPM may be summarized as follows.

In efficient markets, the returns are a linear function

of risk. The relevant measure of risk is 3; and the 3 of a

portfolio is "simply an average of the individual security

betas, weighted by the proportion of each security in the

73Franco Modigliani and Gerald A. Pogue, "An Introduction to Risk and Return," Financial Analysts Journal, 30 (May, 1974), 82.

74 Ibid.

93

portfolio."75 Therefore, to obtain higher returns for an

efficient portfolio, simply select an efficient portfolio

with a higher 8 7 6 and, conversely, for lower returns, hold

an efficient portfolio with a lower g coefficient. Hence, portfolio

analysis and selection involves little more than continually

monitoring the portfolio volatility and adjusting it . . 77

through addition/deletion of higher/lower 6 securities.

Practical Portfolio Management

In spite of the tremendous research and academic

writings on the EMH and CAPM, remarkably little of this

thinking has been reflected in the day-to-day management

of portfolios by the actual portfolio managers. For

example, in spite of the purported efficiency of the capital

75Modigliani and Pogue, "An Introduction to Risk and Return," Financial Analysts Journal, 30 (April, 1974), 78.

76Although the number of securities required to have a diversified portfolio is a function of the volatility of the portfolio, studies have indicated that 8 to 10 securities give a reasonably diversified portfolio; see Robert C. Klemkosky and John D. Martin, "The Effect of Market Risk on Portfolio Diversification," Journal of Finance, 30 (March, 1975), 147-54.

''"''For a rigorous demonstration of this see Guilford C. Babcock, "A Note on Justifying Beta as a Measure of Risk," Journal of Finance, 27 (June, 1972), 699-702. Babcock points out that "a risky security can be used to lower the variance of a diversified portfolio if and only if its beta coefficient is less than the beta coefficient of the portfolio," (p. 702); the opposite holds true. The validity of 8 as a measure is often questioned due to the possibility that it changes over time; for a discussion on this, see: Robert A. Levy, "On the Short-Term Stationarity of Beta Coefficients," Financial Analysts Journal, 27 (November, 1974), 551.

94

markets, mutual fund turnover increased from about 16% per

79,

year in the mid-1960's to about 43% in the early 1970's.

Thus, the mutual funds were increasing their efforts to pro-

vide superior performance even though the current market prices

supposedly reflected-all information on the securities bought

and sold.

Portfolio managers suffer several practical problems.

First, they act as fiduciaries for the ultimate owners of

the assets. This means, among other things, that the

managers must create a long-lasting organization that can

meet the future requirements of the asset owners; this is

particularly important for trusts and pension funds, and

nearly as important for investment companies. Second, the

portfolio managers must work within a variety of constraints.

The most obvious constraints are those imposed by the capital

markets themselves—that is, what is feasible at any point

in time. In addition, constraints are imposed by regulatory

bodies, the ultimate asset owners, and by the managers

79 themselves. The general objective of these constraints

^1974 Mutual Fund Factbook (Washington, D. C. 1974), p. 78.

79 For a framework' of viewing constraints in general,

see: Fremont E. Kast and James E. Rosenzweig, Organ izat ion and Management—A System Approach (New York, 1970), pp. 49-50. For a general discussion of formal as well as informal constraints on managerial action, see: William G. Scott, Organization Theory (Homewood, Illinois, 1967), pp. 399-405. For an excellent discussion of the impact of constraints on investment management, see: Harry C. Sauvain, Investment Management, 4th Ed. (Englewood Cliffs, N.J., 1973), pp. 291-326.

95

is to prevent undesirable outcomes, e.g., loss of capital,

conflicts of interest, etc. However, portfolio managers

generally try to avoid these constraints because of the

belief that constraints on managerial actions reduce

potential returns. For example, one author expressed this

belief as:

investment managers are more likely to produce good or even superior performance if left relatively unconstrained and allowed to vary investment policy and portfolio composition in accordance with their current expectations for individual stocks and for the market as a whole.80

In spite of this desire to remain unencumbered by

constraints, many portfolio managers constrain themselves

through applying such devices as: maximum percentage

invested in one security/industry, "buy lists", etc. For

example, portfolio managers are torn between two factors

when considering the size of the "buy list" (if these are

used at all). On one hand, "investment performance can

often be improved by expanding the list,"81 while conversely,

the "portfolio manager also wants to minimize his administra-QO

tive costs which increase as the number of issues... increase."

80 John G. McDonald, "Investment Objectives: Diversification,

Risk, and Exposure to Surprise," Financial Analysts Journal, 31 (March, 1975), 42.

83 'W. H. Wagner and S. C. Lau, "The Effect of Diversifi-

cation on Risk," Financial Analysts Journal, 27 (November, 1971),53^, This is an extremely interesting ^ article on the subject of diversification.

Q2 Marvin Rosenberg, "Institutional Investors: Holdings,

Prices, and Liquidity," Financial Analysts Journal, 30 (March, 1974), 53 .

96

Looming over all decision making is the fact that

portfolio managers are fiduciaries and suit can be brought

whenever an interested party believes that a violation of

the fiduciary responsibility has taken place. That is,

"policies are determined with the expectation that they

83

will have to be defended" particularly in a court of law.

Put another way, "the overriding fear is the always present

possibility of a surcharge action, whether justified or 84-

not...for an alleged act of improper management." In a

graphic parallel, the portfolio manager may be "in the same

position as the French Army was in World War II behind its

Maginot Line. At the very best, they could only defend

their own territory. Aggressive action and mobility were Q jr

all but impossible."

Another problem area is that many portfolio managers

prefer to operate without explicit portfolio objectives.

In spite of the widely held conviction that all managers

need explicit, identifiable objectives, portfolio managers

often prefer vague objectives. For example: 83 James E. Cox, "Trust Investment Committees: Making

Them More Effective," Trusts and Estates.108 (August, 1969), 803.

^Ibid.

85Ibid.

97

Louis Harris surveyed internal managers of endowment funds on the "guidelines" they would specify for an external investment manager. Assuming full discretion would be given, fewer than three in ten responded that they would specify current income and capital growth targets, set total rate of return objectives, or instruct the manager as to risk criteria. 86

Portfolio managers may prefer objectives stated in only the

most general form for several reasons:

It provides maximum protection from legal or regulatory action. It prevents investors from comparing stated portfolio objectives with actual performance... Managements may avoid statements of objectives in order to maintain flexibility in coping with developments.87

In spite of the reluctance of portfolio managers to

proceed within the framework of specific objectives that can

be translated into operational terms, most writers agree

on certain components of traditional portfolio management.

These components are: (1) economic analysis; (2) industry

analysis; (3) security analysis and selection; (4) market

88

timing; and (5) execution. Crerend postulates that all

portfolio management organizations can be described within

this framework (see Table V); typical examples of the "top

down" style of investing are large banks and large mutual-

fund investment advisors ; examples of the "bottom up" 8£S McDonald, o£. cit.

87 W. Scott Bauman, "Evaluation of Prospective Investment

Performance," Journal of Finance, 23. (May, 1968), 283.

William J. Crerend and Edward Broom, "A Taxonomy of Money Management," Financial Analysts Journal, 30 (May, 1974), 25.

98

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99

style are independent advisory firms, while "market

oriented" examples include small, one individual investment

advisors.89 Most of the performance studies cited earlier

deal with managers of the first two types; there .is a

dearth of research on the results of individual advisors

such as those managing hedge funds or partnerships.

Central to any of the five components discussed above,

is the ability to forecast the future conditions in the

economy, industries, and capital markets. Both the outcome

of investment decisions as well as the strategy necessary to

cope with the future environment are a function of fore-

casted conditions. Even naive "buy-and-hold" strategies

are based on the implicit forecast that future conditions

will not be significantly different from past or current

conditions. The ability to forecast individual security

returns and/or to forecast market returns greatly affects the

selection of an appropriate strategy. Table VI shows a

decision matrix of the appropriate strategies that would be

90 m

associated with various forecasting capabilities. The

existence of such terms as "good" forecasting indicates that

Ambachtsheer implicitly rejects the more rigorous forms of

the EMH. The ability to forecast has many implications in O Q

Crerend and Broom, oj). cit., 26.

90Keith Ambachtsheer, "Portfolio Theory and the Security Analysts." Financial Analysts •Journal, 28 (November, 1972), 53-54. ~

100

. TABLE VI

DECISION MATRIX ILLUSTRATING APPROPRIATE PORTFOLIO POLICY FOR EXISTING

FORECASTING ABILITY

Ability to Forecast Market Returns

GOOD POOR

Ability to Forecast: Specific Security Returns

GOOD

POOR

Run concentrated portfolio

Manage beta around long-term average desired

Run concentrated portfolio

Keep beta at desired long-term average

Run well diversified portfolio

Manage beta around desired long-term average

Run well diversified portfolio

Keep beta at desired long-term average

Source: Keith Ambachtsheer, "Portfolio Theory and the Security Analyst,' Financial Analysts Journal, Vol. 28 (November, 1972), p. 53.

101

terms of observable portfolio characteristics. For example:

The investor who achieves a particular level of performance solely through his capacity to predict market returns will tend to be significantly less active than the,investor who has wider forecasting powers. @1

By implication, the managers who have or believe they have

wider forecasting ability will have higher turnovers.

Sharpe points out even wider forecasting ability may be of

limited value: "Attempts to

to produce incremental return

„9

time the market are not likely

s or more than four percent

2 per year over the long run,

;

The previous discussion has dealt with many of the

practical aspects of portfolip management such as investment

constraints, investment policy, components of investment

management, etc. The discussion is somewhat disjointed

because this is the way that authors in the field tend to

deal with the subject, i.e.,

systematic framework for anal

The next section attempts to

iterative framework for viewi

management. It is in the fol

development of the portfolio

there is little agreement on a

yzing portfolio management,

define a sequential and

ng the task of portfolio

lowing section that the

management process (PMP) is

S.D. Hodges and R. A the Security Analysts," Finan (March, 1973), p. 58. .

Brealey, "Portfolio Theory and cial Analysts Journal, 29

92 kely Gains from Market Timing," William F. Sharpe, "L.iJ Financial Analysts Journal, 21 (March, 1975), 67.

102

discussed.

Portfolio Management Process (PMP)

The concept of a process of management has evolved

from the development and statement of the functions that

managers perform. That is, "the terms function and process

are used with the same meaning in the management context,

and...refer to areas of activity—things the manager does."9"^

Further, "the sum total of all management functions (or

processes) is the management process."94 Although all

efforts at managing must be made within the framework of the

managerial functions, there are criticisms of this approach.

Probably the most incisive critique deals with the lack of

precision in defining the functions; this lack of precision

appears in this research during the effort to define unique,

quantifiable measures for each portfolio management stage.

The problem is obviously "a lack of clearly defined and

mutually exclusive concepts."95 The functions of the

portfolio manager will be discussed later in this section.

p. 44

94

9 3 John B. Miner, The Management Process (New York, 1973),

Ibid.

95. Ibid., p. 50. For a further criticism of the functional

o? ?iifC?SS !?pr°acl1' s e e PP- 50-51. For an excellent comparison of the functional or process approach as compared to other managerial approaches, see Harold Koontz and Cyril O'Donnell

(NeS°Ygrk? ff72)7appme§|i3S— A n a lr s l s ^ Managerial Functions

103

In spite of the volumes written on portfolio management,

there are only a limited number of systematic frameworks that

have been presented for the portfolio management process.

Three of these frameworks are presented here. The first

systematic framework discussed is the "trust investment

96

process" (TIP) developed by Clarkson. Clarkson suggests

that trust investment can be decomposed into three main

areas: (a) selecting from a list of acceptable securities

a sublist of the most promising securities; (b) developing

an investment policy for each trust account; and

(c) selecting a portfolio of securities from (a) suitable 97 , .

to the policy developed in (b). Figure 7 illustrates this

process; note that little concern is given either to feedback

between the tasks or to portfolio evaluation. The TIP

model deals primarily with information flow forward to

succeeding stages. Portfolio revision and evaluation

apparently are of lesser consequence if the initial decisions

were "appropriate." This is particularly true when the

original list of securities is composed of "investment

quality" securities and this list is further screened to

determine the best of the investment quality stocks. Under

this approach, "the essence of the process lies in carrying 98

the prior analysis to its logical conclusion." The prior

a a Geoffrey P. Clarkson Portfolio Selection : A

Simulation of Trust Investment (Englewood Cliffs, N. J., 1962), pp. 28-36.

0 7 q q Ibid., pp. 28-9. "Ibid., p. 28

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105

analysis that Clarkson references is the definition of a list

of investment quality securities and the selection of the

best of this investment grade list.

The portfolio management functions that Clarkson feels

are important are portfolio planning, investment analysis,

and initial portfolio selection. Within the portfolio

planning function, Clarkson suggests the following tasks:

determine the economic background of the client; determine

the objectives of the client; and develop an appropriate

investment policy relative to the economic position and/or

goals of the client. Tax considerations are integrated at

this point. In Clarkson*s view, investment analysis

includes analysis of the economy, industries, and those

companies on the list of "investment grade securities."

Investment expectations are generated; relative performances

and valuation are reviewed. Last, a set of "scanner-selector"

rules are used to select the best set of the investment-

grade securities. The third area of concern to Clarkson is

portfolio selection. Here, the reduced list is further

screened to select securities appropriate to the goal of the

client; diversification and size of commitment constraints

99

are applied at this stage. The PMP description for

portfolio planning, investment analysis, and portfolio

selection shown on Table I shows an obvious resemblance to

this discussion by Clarkson.

Ibid., p. 28.

106

The next framework considered here is by Mennis in his

description of managing growing pension f u n d s . F i g u r e S

illustrates the "investment decision" as suggested by Mennis.

Like Clarkson, Mennis provides a sequential framework and

similarly ignores formal information feedback channels.

Mennis illustrates more clearly the relationship of portfolio

management to the environments in which the management of

financial assets occurs. Mennis includes risk/return ;•

preference, tax considerations, liquidity preference, and

current income/capital gain preference as part of the

investment planning phase. One of the most important

aspects in developing investment policy, according to Mennis,

is establishing a fixed income/variable return ratio;

diversification is also an important policy variable.

Within investment analysis, Mennis suggests the traditional

economic, industry, and company analysis. Portfolio

selection includes selecting the specific investment media

as well as timing individual purchases. Portfolio revision

is given limited discussion by Mennis, although emphasis

is placed on:execution of transactions. Performance

evaluation is pointed out as a required function, but Mennis

does not discuss how this is accomplished or how the results

are fed back to the process of making investment decisions."'"®^

dmund A. Mennis, CFA, "Investment Policy for a Growing Pension Fund," Financial Analysts Journal, 24 (March 1966) 1966) , .121-131.

101Ibid., pp. 122-5, 130-1.

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108

The last portfolio management framework discussed

here is the "global model of portfolio management" 1 02

given by Smith. Smith points out that most "approaches

to the portfolio management process...are incomplete...

[previous discussions fail to emphasize that] portfolio

management is a dynamic process,...in addition... investment 103

management is also an adaptive process." Smith's

model includes portfolio planning, investment analysis,

portfolio selection, portfolio evaluation and portfolio

revision. In Smith's words, "the dynamic nature of the

portfolio management process is explicitly recognized in

the portfolio revision step, while the adaptive character-104

istic is inferred in the several feedback loops. In

contrast to the models of Clarkson and Mennis, Smith

explicitly deals with feedback requirements. However,

unlike Mennis, Smith's model shows no explicit environmental

interaction nor does the model explicitly integrate with

the primary managerial functions of planning, executing,

and controlling.105

The general framework of portfolio management as a

basic system is shown in Figure 1; the portfolio management

process developed by previous authors are shown in Figure 7

(Clarkson) and Figure 8 (Mennis); these provide a substantial 1(^Keith V. Smith, Portfolio Management (New York, 1971),

pp. 40-55. 103Ibid., p. 41. 104Ibid., p. 42 105Ibid., pp. 41-55.

109

background in developing a systematic portfolio management

framework. Smith's "global model" provides the basic

framework from which the portfolio management process (PMP)

was developed (see Figure 2); this PMP provides the

analytic framework in this research. Figure 9 illustrates

the PMP within the many environments that affect portfolio

decisions. Note that Figure 9 illustrates the interaction

of portfolio management and its many environments as well

as showing PMP within the basic managerial functions of

planning, executing and controlling. The PMP shown in

Figure 9 is both iterative and sequential in nature and

clearly illustrates the important feedback relationships.

The many functions of portfolio management—as described

by Clarkson, Mennis, and Smith—have been discussed above.

Table V presents some of the characteristics and functions

of various portfolio management organizations according to

the taxonomy of Crerend and Broom. Table VII illustrates

the various functions according to Clarkson, Mennis, and

107 Smith. Although the tabular entries are not meant to be

-J A / J

Crerend and Broom, op. cit., 25-27.

1 07 Clarkson, op. cit., Mennis, op. cit., pp. 122-31;

Edmund A. Mennis, "An Integrated Approach to Portfolio Management," Financial Analysts Journal, 30 (March, 1974), 38-46+; Smith, 'op. cit., pp. 40-55. For an interesting view of analyzing the efiiciency of certain portfolio manage-ment functions, see: Peter 0. Dietz, "Components of a Measurement Model: Rate of Return, Risk, and Timing," Journal of Finance, 23 (May, 1968), 267-75.

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an exhaustive list, the functions indicated are typical.

Table V and Table VII represent a summary of the work of

various authors, and more importantly, represent the basis

of the PMP description presented in Table I. Hence, the

PMP (see Figure 2) and its description (see Table I) have

a substantial theoretical and practical background. The

development of Figure 2 and Table I are now apparent.

With this review of portfolio theory and practice as a

background, the following discussion presents a summary of

the literature on the dual-fund industry.

Review of the Dual-Fund Industry

The dual-fund industry was initiated in Great Brit&in

108

in 1965 with the creation of "Dualvest, Ltd." The

British dual funds quickly grew to around a dozen of the

so-called "split-capital trusts;" the substantial British

interest in these new leveraged investment companies stemmed

from the higher tax rates in Great Britain and the "more 109

highly developed sporting blood of Britishers." The

successful initial sale and subsequent market action—most

British dual funds sold at a premium over net asset value

during the first several years after issue—encouraged

United States investment managers and underwriters to try the

concept here. 108

James A. Gentry and John R. Pike, "Dual Funds Revisited," Financial Analysts Journal, 24 (March, 1968)", 155.

"^^Armon Glenn, "Double Trouble," Barron's (September 2, 1968), 3.

113

The dual-fund concept had a substantial hurdle to

overcome before being marketed in the United States.

The hurdle was the Securities and Exchange Commission (SEC)

as well as the various state securities regulatory agencies.

The original British pattern involved as much as 80 percent

of original capital provided by preferred shareholders.

This was unacceptable to U.S. regulators because "the

Investment Company Act forbids a fund to sell senior shares

unless its other assets available for 'coverage' are at

least equal in value. The SEC was also concerned that

portfolio managers would concentrate on one class of

investors at the expense of the other class. State regulators

were also concerned about this point as well as the structure

of funds "which reminded them, they said, of those highly

leveraged closed-end investment companies that were so

popular in the late 1920's (and were so devastated...in 1929).n111

After about one year of dealing with regulators'

concerns, the dual funds were approved by the SEC with a

variety of additional restrictions; the most important were:

(1) income shareholders were entitled to a fixed, minimum

cumulative dividend; (2) the companies could not engage in

speculative techniques; and (3) the companies could not borrow

^"^Carol J. Loomis, "Those Loaded, Double-Barreled Closed-End Funds," Fortune, 81 (February, 1967), 201.

n i I b l d .

114

112 money or repurchase shares. The dual funds "began

i n

racing each other to market," "" eventually raising some

$300 million starting in March, 1967. Regardless of any

subsequent portfolio performance, "the funds certainly

performed well from the merchandising point of view."114

The delays apparently did not hurt the initial sales of the

funds but all involved were relieved that the sales were

successful; dealers in particular were glad the sales

were begun because "they (had) been under the gun from

incensed investors (who) lined up for the dual-fund shares 115

the previous year."

Demand for the two different classes of shares was

uneven—investors were very interested in the income shares

but less interested in the capital shares.116 "One probable

reason for the greater popularity of the income shares is

that the payoff...seems much more assured."117 In one view,

"prospects for the capital shares are less certain,

119 ""Five 'Dual Funds' Are Approved by SEC; Restrictions

Imposed on Their Operations," The Wall Street Journal, March 23, 1967, 11.

11^Loomis, op. cit.

114 "Dual Purpose Fund Results," Fortune, 82

(August, 1967), 175. 115

"Dual Funds Ready to Go." Business Week (March 18. 1967), 150.

116 t . .. . juoomis , op. cit. , 206.

i t rr

Ibid.

115

particularly for investors trying to decide whether to buy

] 18

them on the original offering."" If the capital shares

sold at a discount from net asset value then buyers would

wait until the shares were publicly traded before making

purchases. Delayed buying of capital shares would completely

disrupt the initial distribution of the dual funds because

the sale of each income share depended on the sale of a

corresponding capital share and vice versa.

To deal with the problems of unequal share demand,

the proposed dual funds made certain changes in their

structures to enhance the capital share position. The capital shares have control of the board of directors"; and !

the investment management fees and expenses are charged

against the income shares (except GEM and HEM which allocate

50 percent of these costs to each share class). In spite of

these efforts, the capital shares sold at a discount; after

issue only two other dual funds were marketed directly to the

public in June, 1967. The two--HEM and PUTNC—were the

smallest of the original seven dual funds. Investor interest

waned and, in spite of claims that many more dual funds would

] 19 be created, " no more were offered to the public.

118T, . . Ibid.

119 Ira U. Cobleigh, "The New Two-To-One Capital/Income

Funds," The Commercial and Financial Chronicle, 205 (April 6, 1967), 3.

116

Industry and academic interest in the dual funds

remained high during 1967-68; the interest was evidenced

by the number of articles during the period that dealt with

dual funds. The best were articles by: Shelton, Brigham,

and Hofflander (S-B-H); Gentry and Pike (G-P); and Johnston,

Curley, and Mclndoe (J-C-M).120 Although each was oriented

toward a different view of the dual-fund industry, the

following discussion will deal with the portfolio management

aspect.

S-B-H deal with the difficult problems of balancing

income share needs and capital share desires; in fact S-B-H

assert that "high current dividend yields are seldom 121

associated with large capital gain potential." This

dilemma was mentioned before in conjunction with SEC and

state regulatory concerns. J-C-M illustrate this condition

when they point out that "the Chinese Yin and Yang has been T O O

used as a descriptive symbol" ~ for one of the dual funds.

120John P. Shelton, Eugene F. Brigham, and Alfred E. Hofflander, Jr., "An Evaluation and Appraisal of Dual Funds," Financial Analvsis Journal, 23 (May, 1967), 131-9; Tames E. Gentry and John R. Pike, "Dual Funds Revisited," Financial Analysts Journal, 24 (March, 1968), 149-57;_ George S. Johnston, M. Louise Anley, and Robert A. Mclndoe, "Are Shares of Dual-Purpose Funds Undervalued?" Financial Analysts Journal, 24 (November, 1968), 157-63.

121Shelt;on, et. al. , ojd. cit• , 133.

2 Johnston, et_. al_. , op • cit. , 157.

117

Relative to this problem, S-B-H conclude:

The policy of 'treat-each-class-of-shareholder-almost-equally' seems to describe more accurately the intentions of dual fund managers than the 'concentrate-on-gain-once-the~preferred-dividend-is-secure' policy. Evidence to support this statement comes partly from unofficial but authoritative answers by fund managers to whom the question was posed.123

G-P concentrate on the role of minimum required

dividends and minimum required return (rate each fund must

earn on total assets to meet requirements—dividends and

124

management charges). In their words: "This minimum

required return can best be thought of as a return floor

that limits investment opportunities, or flexibility, hence, 1 9R

it is a measure of dual fund risk taking capacity." G-P

calculate minimum required returns for the original five

(5) dual funds (see Table VIII); they conclude that "the

investment opportunities available to Scudder DuoVest appear 1 PR

more limited than those available to Gemini Fund."

Prophetically, G-P state: "Gemini may have the opportunity

for greater growth of assets because it can accept greater 127

risk than Scudder." An article in Forbes in February,

1976, points out that as of that writing, GEM, was the only 1 OQ

dual fund whose portfolio had appreciated since inception. 123

Shelton, et. al., op. cit. 124

Gentry and Pike, op. cit. ,149. 12oIbid., 154. 128Ibid. 127Ibid., 155.

128 "For Leverage Lovers," Forbes (February 1, 1976), 68+,

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The consideration of meeting the guaranteed dividends is

dealt with by S-B-H. They poiiiit out that as the fund grows

larger, "the smaller the annual dividend yield needs to be... 129

in order to treat both classes of shareholders equally."

However, the reverse is also true; as the fund shrinks in

capital value, the larger the income yield must be to treat

the two classes of shareholders equally. The thought of

capital values actually shrinking may not have been a

widespread view in the "go-go" years of the mid-1960's. In

addition, the cumulative nature of the dividends paid to

income shareholders poses the possibility "that unpaid pre-

ferred dividends would cumulate and...cause unhappiness to 130

the income shareholders." This in turn would cause

"unhappiness" and extra restrictions for the fund managers.

G-P did not include all of the original seven (7) funds

in their analysis; HEM and PUTNC have been added to Table

VIII for comparison but G-P's conclusion would have remained

the same since both HEM and PUTNC fall between the lowest

required return (GEM) and the highest required return (SDV).

Since G-P did. not consider PUTNC, they did not evaluate the

impact of increasing dividends that PUTNC "guaranteed."

The existence of scaled dividends is included in this

research in the form of variables IP3 and IP6 (see Chapter

II and Appendix A). G-P also did not consider operating 129Shelt;on, et_. al_. , o£. cit. , 136.

130lbid., 138.

120

expenses above and beyond the standard management fee.

Again this research includes these factors in the form of

variables IP5, and IP6, and IP7 (see Chapter II and Appendix

A). Last, G-P did not consider the amortized difference

between the capital contributed by income shareholders and

income share redemption value at fund termination; this

research considers these factors with variables IP4 and IP7.

All the previously mentioned omissions by G-P occur during

the initial portfolio planning phase of the PMP and,

obviously, impact all subsequent portfolio policy.

G-P describe the possibilities available to the dual-

fund managers in terms of Baumol's risk-return model and

state:

The higher the existing investment return possibilities turned out to be, the farther from the origin the frontier facing the funds will be. The higher the efficient portfolio frontier relative to the required return of a particular fund, the greater the flexibility available to management in choosing an efficient portfolio. If, however} investment possibilities available are more limited ..-.the range of flexibility open to fund managers is reduced.131

Given the extremely volatile capital markets of mid-

1967 through 1973, the above observation is probably G-P's

greatest contribution concerning the dual-fund industry.

J-C-M argue that the dual fund concept is not

contradictory. In fact J-C-M state: "the dual investment

goals are achieved by a partnership between investors with

131 Gentry and Pike, op. cit.

121

132

complementary goals." Since one of the co-authors,

Johnston, has been the portfolio manager of SDV since

inception, this argument may have substantial insight,

bias, or both,. Many observers both inside and outside of

the dual-fund industry felt convertible securities would

be excellent investment media to meet the two requirements

of income and growth. In fact, "the majority of the dual

funds employ a sizable proportion of convertible bonds 133

and preferreds for this purpose." This view ignored

the possibility that both the stock and bond markets would

suffer substantial declines simultaneously.

In spite of the substantial initial interest in the

dual funds, little research has been published on these

unique investment companies. A study by Kumar is one

exception to this lack of publication on the dual fund

134

industry. However, Kumar uses the dual funds simply as a

comparison for his use of a goal programming approach to

portfolio selection. 132

Johnston, et. al., op. cit., 159. 1 33

Glenn, op,, cit. , 8. 134

Parmeswar Kumar, "Multiple Criteria Portfolio Selection in Dual-Purpose Funds: A Goal Programming Approach," Unpublished Ph.D. Dissertation, The Pennsylvania State University (.State College, 1975). Another interesting Ph.D. dissertation deals with the investment performance of the capital shares; see: George H. Troughton, "Investment Performance and Appraisal of Dual Purpose Funds' Capital Shares," Unpublished Ph.D. Dissertation, University of Massachusetts (Amherst, Massachusetts, 1974).

122

This chapter covers both the theoretical and practical

aspects of portfolio management, the development of the

portfolio management process (PMP), and a brief discussion

of the literature on the dual-fund industry. With this

background the following chapter presents the quantitative

and qualitative results of this research.

CHAPTER IV

RESEARCH RESULTS

Introduction

This chapter is broken into three main sections: the

first is a discussion of the quantitative results of this

research. The quantitative section includes the presentation

of performance for the dual funds as well as the regression

analysis of performance versus quantitative measures for

each portfolio management stage. Also included in the

quantitative discussion is the analysis of the portfolio

characteristic lines for each dual fund. The second

section of this chapter presents the qualitative results

of the research. Included here are the analysis of the

public reports published by the dual funds as well as a

discussion of the results of the dual-fund portfolio

management survey. A brief selection summarizes and

integrates the quantitative and qualitative analysis.

Quantitative Research Results

This section covers three main areas. The first area

presents the performance of the dual funds from inception

through 1973. The performance is presented in three

forms: (1) absolute performance, i.e., average annual

123

124

percentage return; (2) performance relative to market

returns; and (3) performance relative to measures of risk.

A computer program, PORTEVAL, was developed by the author

to perform this analysis; the program listing and a sample

output are given in Appendix D. The analysis of the

portfolio characteristic lines for each dual fund completes

the performance measurement section. The second area

presents a regression analysis of performance versus

quantitative variables defined for each stage of the

portfolio management process (PMP). The linear regression

is extended into step-wise regression for performance

versus variables representative of each PMP stage and for

the PMP as a whole.

Dual-Fund Performance Measurement

The arithmetic mean return (AM), arithmetic risk

premium to variability'(RPTV), and geometric mean (GM) f o r

each dual fund are shown in Table IX. The need for analyzing

the arithmetic risk premium to variability and geometric

returns is discussed in Chapter II; the RPTV used here

follows the definition of 4> as defined by Sharpe (see

Chapter II). Note the consistent ranking of the dual

s for each performance measure. Regression of RPTV or

GM on AM indicate a strong, positive correlation; coefficient

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126

of determination greater than 0.98 for each regression line

indicate that the three variables can be used essentially

2

interchangeably for each other.' Therefore, the balance

of the research uses the arithmetic mean as the measure of

performance due to the ease of interpreting results.

Tables X and XI illustrate the cumulative and year-by-

year gross portfolio returns (before management fees and

expenses) for each dual fund as well as for the Dow-Jones

Industrial Average (DJIA) and the Standard & Poor's (S&P)

Index. From Table IX, note that only GEM, ICS, and SDV had

gross, cumulative returns higher than both the DJIA and the

S&P 500 for the time period under analysis. When year-by-

year results are examined, note that no dual fund ranked

above the dual-fund industry median for each and every year.

HEM on the other hand, never performed above the industry

median for the time period(see Table XI).

The year-bv-year rankings in Table XI create an

opportunity for statistical test of the null hypothesis that

the inter-year rankings are not related. Using "Kendall's

Coefficient of Concordance," W, the null hypothesis was o

tested and accepted at the 5% level of significance.

2 In a similar but more extensive analysis, Gaumnitz

concluded: "the mean return on a portfolio.. .can be used as a good proxy for the theoretically correct (risk premium to variability) value." Jack E. Gaumnitz, "Appraising Perfor-mance of Investment Portfolios," Journal of Finance, 25 (June-; 1970) , 559,

3 See Sidney Siegel, Nonpararnetric Statistics for the

Behavioral Sciences (New York, 1956), pp. 229-38.

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The null hypothesis could be rejected at approximately the

25% level; this does indicate the possibility of a very

weak correlation of the int'er-year rankings. The lack -

of consistent performance over time corresponds to the

4

results of Sharpe, Jensen, and Williamson.

Table XII shows the number of years that each dual

fund had gross portfolio returns greater than either the

DJIA or the S&P 500. Note that ICS, GEM, and SDV frequently

had annual gross returns higher than the two averages;

HEM managed to out-perform only one index in one year.

The comparison of the risk-premium-to-variability for the

dual funds to the DJIA and S&P 500 (see Table IX) produces

results quite similar to those shown in the research by

Jensen and Sharpe. The apparent inferiority of HEM

contrasts somewhat with the research cited above of

Williamson who states "there seems to be no evidence that 5

any funds are consistently in the bottom 40 percent.

Portfolio Characteristic Lines

Table XIII illustrates the a and 3 for each dual fund as

measured against the S&P 500 for the period from inception

4 William F. Sharpe, "Mutual Fund Performance," Journal

of Business, 39 (January, 1966), 119-38; Michael C. Jensen, "The Performance of Mutual Funds in the Period 1945-65," Journal of Finance, 23 (May, 1968) 389-416; Peter J. Williamson, "Measuring Mutual Fund Performance," Financial Analysts Journal, 28 (November, 1972), 78-84.

5 Williamson, ojd. cit. 82.

130

TABLE XII

NUMBER OF YEARS FRCM 1967 TO 1973 THAT EACH DUAL-FUND HAD ANNUALIZED GROSS RETURNS GREATER THAT TOTAL RETURN FOR DOW-JONES INDUSTRIAL AVERAGE (DJIA) AND STANDARD &

POOR'S 500 STOCK INDEX (S&P500)

Dual-Fund Stock Symbol

INDEX Dual-Fund Stock Symbol DJIA S&P500

ADV 3 2

GEM 5 4

HEM 1 0

ICS 5 5

LFB 3 4

FUINC 3 3

SDV 6 3

NOTES: For 1967, the annualized gross return for each fund was compared to the respective average/index for the comparable time period from inception to December 31, 1967. For all other years, annualized returns calcula-ted for entire calendar year.

Total Return'' for DJIA and S&P500 stock measures are defined as capital appreciation (or loss) ulus "equivalent" dividends as indicated by respective source.

131

TABLE XIII

SLOPE (3) AND INTERCEPT (a) AND COEFFICIENT OF DETERMINATION FOR PORTFOLIO CHARACTERISTIC

LINES MEASURED AGAINST S&P500 INDEX

Dual Fund

Slope (8)

Intercept (%) (a)

Coefficient of Determination

/ M V ^

(r )*

ADV 1.047 -2.543 0.680

GEM 1.228 +2.556 0.878

HEM 0.903 -9.236 0.747

ICS 1.199 +2.623 0.789

LFB 1, 017 -1.189 0.878

PUTNC 0.859 -7.125 0.710

SDV 0.844 +0.306 0.899

Industry Average 0.797

* The coefficient of determination indicates the percentage of total variation in the regression equation that is explained by variation in the causal variable(market returns). A coefficient of determination of 1.000 indicates a perfect correlation and explanation between causal and dependent variables.

132

through 1973. The a and $ shown in Table XIII are the

intercept and slope of the portfolio characteristic line as

6 2 defined by Jensen. The coefficient of determination (r ) o

is also shown on Table XIII; the higher the value of r ,

the more efficient the portfolio; i.e., the greater the

correlation of the market returns and portfolio returns.

Note that none of the dual funds have a perfect relationship

with the market and only GEM, LFB, and SDV have reasonably

efficient portfolios. As a result, the variability of

returns—not the volatility of returns—is the appropriate

measure of risk (as indicated in Chapters II and III). The

fact that a portfolio is not efficient is not necessarily 2

bad. A portfolio could have a low r , because management

was exceptionally adroit at timing or making changes in

2 the major mix of securities. Likewise, a low r could be

7 indicative of particularly poor management. Only by

inspecting the curvature of the portfolio characteristic

2

curve can a conclusion be reached about the r developed

from the linear characteristic relation. This analysis is

performed in a subsequent section.

"PORTEVAL" calculates A and B(intercept and slope) according to Jack L. Treynor, "How to Rate Management of Investment Funds," Harvard Business Review," 43 (January, 1965), 63-75. Tables XIII uses the transfor-mational equations given in Keith V. Smith, Portfolio Management (New York, 1971), p. 192, to obtain the format of Jensen, op. c i t t o determine a and 8.

7 James H. Lorie and Mary T. Hamilton, The Stock Market

(Homewood, Illinois, 1973), pp. 200-1, 254.

133

Table XIV illustrates the 95% confidence intervals for

the "true" a and 3 for the dual-fund portfolio characteristic

lines.8 The confidence intervals indicate that both GEM

and ICS generated "excess returns...beyond the return

predicted by the (capital asset pricing model) CAPM on the

basis of the asset's beta value.Similarly, ADV, HEM, and

PDTNC generated returns below that predicted by the CAPM.

LFB and SDV performed in line with the CAPM. From Table

XIV, it is obvious that GEM, ICS, and—to a lesser extent

ADV, all had portfolios with volatilities greater than the

market (S&P 500); that is, these three had portfolios more

risky than the market for this time interval. LFB was about

as risky as the market while HEM, PUTNC, and SDV had lower

volatilities than the market.

A comparison of returns and measures of risk for the

dual-fund industry are shown in Table XV. The regression

equations for arithmetic return versus volatility and

variability are shown. Note that variation in volatility 2

($c) of returns only explains about 33% (i.e., rJ) of the

variation in arithmetic returns. Changes in the variability

of returns explain about 75% of the variation in arithmetic

returns. The low predictive ability of "B" is the result of

several factors. First, the dual-fund portfolios were not

8For a discussion of this type of analysis, see: J. Peter Williamson, Investments: New Analytic Techniques (New York 1970), pp. 270-275; and Franco Modigliani and Gerald A. Pogue, "An Introduction to Risk and Return," Financial Analyst5

Journal. 30 (May, 1974), 73-4...

^Modigliani and Pogue, op. cit., 73.

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TABLE XV

CCMPARISCN OF GROSS ARITHMETIC RETURN (AM) AND RISK FOR DUAL-FUND INDUSTRY AGAINSI S&P500 THROUGH 1973*

Dual Fund Gross Ari true tic Mean Return. (%)

Volatility (0)

Quarterly Variability cf Arithmetic Return

^SAM)

ABV +2.83 1.047 35.47

GEM +7.99 1.228 36.60

HEM -3.90 0.903 29.75

ICS +8.05 1.199 37.71

LF3 +4.17 1.017 30.30

PUTNC +3.97 0.859 29.02

SDV +5.61 0.844 24.86

•k Regression Equations:

AH « -10.949 + 14.346 (3)

(r2 « .327)

AH = -6.31 + .326 (S^)

(r2 » .748)

136

efficiently diversified during this time interval (see Table

XIII). Secondly, the dual-fund industry averaged about 30%

of investments in securities other than common stocks. Hence,

the low degree of correlation between stock market returns

and portfolio returns is not surprising for the industry as

a whole. In spite of the fairly high degree of correlation

between returns and variability of returns (i.e., risk) note

that 25% of the variation in arithmetic returns cannot be

explained directly by changes in risk levels.

Linearity of Portfolio Characteristic Line.—Previous 2

discussion raised the question of what causes the r for the

portfolio characteristic lines to be as low as is indicated in

Table XIII. One obvious reason could be a lack of linearity

between portfolio returns and market returns. A second-order,

parabolic portfolio characteristic line was developed for each

dual fund (see Table XVI).10 The size of the regression coeffi-

cent "C" indicates that non-linearity between portfolio returns

and market returns is not a factor. In fact, the best

improvement (for ICS) only represents a 0.4 percentage point

better explanation of variation. Therefore, the analysis of the

portfolio characteristic curves indicates that the dual-fund

managers were not able to "outguess" the future trends of the

markets. This conclusion is the same as reached by. Treynor and

100f course, relationships other than parabolic are possible. However part of the PORTEVAL output is a graph of portfolio re-turns and market returns. Visual inspection of the dual funds indicates no potential relationship other than linear (see Appendix D).

TABLE XVI 137

COEFFICIENTS OF SECOND-OBDER (PABAEOLIC) PORTFOLIO CHAEACIERISTIC LINES FOR DUAL-FUND INDUSTRY

AGAINST S&P500 AND COMPARISON OF "GOODNESS OF FIT"

Dual Fund Parabolic Coefficients* A B C

Coefficient of Multiple Determination

Coefficient of Determination for Linear Portfolio Characteristic Curve

ADV -3.116 1.047 0.000 .681 .680

GEM 0.863 1.226 0.001 .879 .873

HEM -8.762 0.903 0.000 .747 .747

ICS 3.143 1.203 -0.002 .793 .789

LFB -1.111 1.017 0.000 .878 .878

FUTNC -1.658 0.856 0.001 .713 ' .710

SDV +1.185 0.844 0.000 .899 .899

Parabolic Coefficients are the result of regressing quarterly portfolio returns versus quarterly S&P500 returns according to the following ecuaG.cn:

AM P

A + 3 (AH t S5?500) + C t, S&P500)

Vnere AM is the return in period "t" for portfolio "p" or

138

Mazuy in an investigation of 57 mutual funds during the 1953-62

time period.11 In conclusion/ there is no reason to believe

that the portfolio characteristic curves are non-linear, i.e.,

management of the dual funds were not able to adjust correctly

the portfolio volatilities prior to market changes.

Buv - an d-Ho I'd Versus Actual Performance. —Table XVII

illustrates the arithmetic return of each dual fund from

December 31, 1967, to December 31, 1973, compared to what would

have occurred if the December 31, 1967, portfolio had been held

unchanged. The ability to outperform buy-and-hold strategies

would be indicative of superior asset selection/divestiture,

timing, analysis, etc., assuming that the risk levels were

held constant. ICS, LFB, PUTNC, and SDV all generated higher

acutal, gross returns than would have buy-and-hold strategies

(no provision is made for any changes in risk levels). After

subtracting management fees and expenses, ICS, PUTNC, and SDV

still generated higher returns. No fees and expenses were

charged against the buy-and-hold portfolios; the net returns

from buy-and-hold strategies would be somewhat less than indi-

cated since some administrative costs would have been

incurred just to meet regulatory requirements.

None of the dual funds that had higher returns than

buy-and-hold generated more than an additional 2.96

percentage points annual returns. This falls within the

11Jack L. Treynor and Kay K. Mazuy, "Can Mutual Funds Outguess the Market?" Harvard Business Review, 44 (July, 1966), 131-6.

TABLE XVII

COMPARISON OF BUY-AND-HOLD STRATEGY FOR EACH DUAL FUND VERSUS ACTUAL RETURNS FOR PERIOD DECEMBER 31, 1S67 TO DECEMBER 31, 1973

139

Dual Fund

Annual Gross Arithmetic Returns for Buy-and-Hold Strategy (%)*

Actual Gross Annual Arith-metic Returns C%)*

Annual Managgnent Fees (%)

Average, Annual:. Portfolio Expenses (%)

Actual, Annual Net Arithmetic Returns (%)**

ADV +0.15 -0.33 0.50 0.43 -1.31

GEM +3.45 +3.38 0.50 0.31 +2.57

HEM +0.67 -5.38 0.50 0.37 -6.25

ICS +0.22 +3.88 0.40 0.35 +3.13

LFB +2.55 +2.58 0.50 0.21 +1.87

FUTNC -2.19 +1.55 0.50 0.28 +0.77

SDV +0.31 +3.83 0.50 0.21 +3.12

*No tax considerations were made for either the buy-and-hold or actual returns to maintain comparability

**Net of Management Fees and Portfolio Expenses

140

maximum 4 percentage points per year that Sharp suggests as

the best possible incremental returns available from superior

market timing.12 However, the superior Cor inferior) actual

returns may be attributable simply to changes in portfolio

risk levels and not to superior (or inferior) asset

selection, timing, et. al.

Summary.—The dual-fund industry can be broken into

three groups based on performance from inception through 1973.

The top group includes GEM and ICS; both ranked at the top

regardless of what performance measure is used (Table IX)

and each outperformed both the DJIA and S&P 500 over the

interval. Both GEM and ICS had better-than-average mean

annual rankings (see Table XI) and outperformed the two

standard indices most frequently (Table XII). In addition,

GEM and ICS both have significantly positive a's (Table XIV).

ICS outperformed a buy-and-hold stragegy while GEM had

actual performance fractionally less than buy-and-hold

(Table XVII).

The second group includes the three dual funds whose

performance generally matched market performance and whose

a^s were approximately equal to zero. This group includes

LFB, SDV, and PUTNC. The results for PUTNC are contradictory

to an extent ;• the overall industry rankings (Table IX and XI)

are consistent with placing PDTNC in this second group.

12William F. Sharpe, "Likely Gain from Market Timing," Financial Analysts Journal, 31 (March, 1975), 67.

141

However, the significantly negative a's shown in Table XIV

indicate poorer performance whereas PUTNC did outperform

the buy-and-hold strategy by a margin greater than any other

dual fund (see Table XVII).

The last group includes the two dual funds with the

worst performance—ADV and HEM. Both ADV and HEM had the

lowest arithmetic and geometric returns as well as the

lowest risk premium to variability (see Table IX). HEM

never ranked above fourth in the annual industry performance

rankings (Table XI) and only outperformed one index in one

year (Table XII). ADV had the lowest portfolio efficiency

using the coefficient of determination as the measure of

efficiency (Table XIII). Both ADV and HEM had significantly

negative a's and both substantially under-performed the buy-

and~hold strategy (Table XVII).

Regression Analysis

The mean arithmetic returns of the dual funds are

regressed against the variables defined in Table IV. The

arithmetic return is used in lieu of geometric mean or risk-

premium- to- variability because of the very high correlation

between these measures that makes the variables essentially

interchangeable (see Table IX and the associated discussion

on performance measurement). Table XVIII presents the

2 intercept, slope, and coefficient of determination (r") for

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each PMP variable regressed against arithmetic mean

13

returns for the industry as a whole. The data used for

this regression analysis is tabulated in Appendix C. The

results of the regression analysis are discussed according

to each of the PMP stages.

Initial Portfolio Planning.—Table XVIII indicates

that no initial planning variable had a high correlation

with mean returns. The planned management fee (IP1) has

a negative relationship with mean returns. However, this

results from the highest returning dual fund, ICS, having

the lowest planned management fee of 0.4% per year; all

other dual funds had planned management fees of 0.5% per

year. The relationship of actual fees and expenses is

discussed in the portfolio evaluation section. Planned

portfolio size shows no correlation to arithmetic returns;

the lack of correlation of portfolio size and returns

corresponds to research conclusions by several 13The "Statistical Package for the Social Sciene (SPSS)"

REGRESSION sub-routine was used for this analysis; the REGRESSION package uses linear regression and, therefore, the relationships between return and various PMP variables are assumed to be linear. Analysis of the graphic output as well as regression residuals was made to test linearity assumptions. Four (4) variables—P52, P53, PR14/PE21, and PR8—were found to have significant non-linearity. Appropriate transformations on these variables were made and all subsequent analysis use the transformed variables to keep as close as possible to the linearity assumption of the SPSS regression technique. See: Norman H. Nie, et. al., Statistical Package for the Social Sciences, 2nd Ed. (New York, 1975), pp. 341—3, 368—72.

146

14 authors.

Continuing Portfolio Planning.—Interest as a percent

of portfolio income (CP1) has a fairly high and negative

correlation with arithmetic returns (see Table XVIII).

That is, dual funds that use higher proportions of bonds

and marketable securities (i.e., lower risk securities) to

generate income, have lower total returns. In addition,

gross current yield (CP2) has no correlation with mean

return even though current yield is a substantial component

of total portfolio return. This may tend to Support the

widely held view that seeking higher current income reduces

* ^ - -.15 capital gam potential.

Arithmetic return has a large and negative correlation

to the average, minimum required current yield (CP3).

The most obvious reason is that as portfolio values decline

(i.e., negative returns), the fixed dividend requirements

of the dual fund cause higher minimum required income. This

observation coincides with the thoughts of Shelton, Brighasn,

and Hofflander (S-B-H) expressed in Chapter III concerning

14For example, see: Frank L. Voorheis, "Bank Trustees and Pension Fund Performance," Financial Analysts Journal, 28 (July, 1972), 61-2; and Irwin Friend, Marshall Blume, and Jean Crockett, Mutual Funds and other Institutional Investors (New York, 1970), p. 60 and 156.

15For example, "Experience shows that seeking direct income of more than 3 percent of any portfolio's capital value results in a substantial reduction of its capacity for growth. "Professional Investing for You," Lioned D. Edie and Co. ^ (New York, 1972), p. 15. Also, see the discussion of duax funds in Chapter III.

147

16

meeting the dual-fund dividends as portfolio value changes.

Further, the excess current yield (CP4=CP3—CP2) has a

substantial and negative correlation to arithmetic return.

Hence, as portfolio values declined, the minimum dividend

requirement went up, necessitating some shift to higher

current yield securities at the possible expense of higher

total-return securities. The reverse was also true; hence,

negative performance in the first several years could impose

substantial burdens on management. As a result, those

funds that did poorly initially (e.g., HEM) tended to

continue to perform poorly while dual funds with good

initial performance tended to remain at the top because

the minimum required income represented little burden (see

Table X). Gentry and Pike discussed this possibility in

1968 and, apparently, their conclusions concerning the

potentially adverse affect of the minimum required returns 17

held true at least through 1973.

Investment Analysis.—None of the quantitative

variables defined for the investment analysis stage show any

significant relationship to arithmetic returns (see Table XVIII) 16John P. Shelton, Eugene F. Brigham. and Alfred E.

Hofflander, Jr., "An Evaluation and Appraisal of Dual Funds," Financial Analysts Journal, 23 (May, 1967), 136.

^.Tampa E. Gentry and John R. Pike, "Dual Funds Revisited," Financial Analysts Journal, 24 (March, 1968), 149-57. Also~see the dUal-fund discussion in Chapter III.

148

Therefore, either this stage is not particularly important

in efficient capital markets or more research is needed to

define meaningful variables for this PMP stage. This latter

alternative is beyond the scope of this current study.

Initial Portfolio Selection.—The initial portfolio

major mix is described by variables PS1 through PS5.

Portfolio returns are positively and significantly related

to portfolio percentage in senior securities (PS2). Since

PS3 (convertible securities) is a subset of PS2, the similar

results for PS2 and PS3 are easily seen. The "conventional"

wisdom of heavy dual-fund commitment to convertible

• - ... - •; 1 8 -

securities appears Unwarranted. The best performing

alternative appears to have placed the bulk of the

portfolio in common stocks.

The industry breakout of initial common stock and

equivalents shows no significant relationship although

portfolio returns are positively related to the percentage

of financial (PS6), transportation (PS7), and utility

securities (PS8) and negatively related to initial percentage

in other common stocks (PS9). Portfolio returns are negatively

correlated with both initial percentage of "Vickers Favorite

50" (PS10) and the Dow Jones Industrial stocks (PS11);

initial commitment to the "popular" and/or "blue chip" stocks

did not lead to better returns. Portfolio returns have x8Armon Glenn, "Double Trouble", Barron's (September 2,

1968), 8.

149

little relationship to either the initial number of

securities (PS12) or the initial amount invested per

security (PS13).

Portfolio Revision.—The portfolio mix variables over

the entire time period show much the same results as do the

initial mix variables (see Table XVIII). Portfolio returns

are significantly and negatively correlated with the

proportion of cash and marketable securities (PR1). Again,

performance is negatively related to the average percentage

of senior securities (PR2) and convertible securities (PR3);

apparently, convertible securities were not the "cure-all"

some had envisioned for the dual-fund industry."'"® At the

same time, performance is positively correlated to the

percentage invested in common stocks. For this time period,

better performance is associated with placing portfolio

assets in the riskier and higher returning financial assets—

common stocks(PR5).

The common stock and equivalent composition shows that

portfolio returns were positively correlated with the

percentage invested in common stocks in the financial (PR6),

transportation (PR7), and public utility (PR8) sectors.

Portfolio returns are correlated negatively with common stock

investment in all other sectors (PR9). Table XIX shows

returns from these various market sectors to provide a

comparison. The returns from the financial and transportation

19 Ibid.

150

TABLE XIX

AVERAGE ARITHMETIC RETURNS FOR VARIOUS MARKET SECTORS AS MEASURED BY DIFFERENT MARKET INDICES FOR

MARCH 31, 1967, TO DECEMBER 31, 1973

Market Sector

Market Index Name

Average Annual Capital Gains or Loss (%)

f — m

r— *

1 Average Annual Dividend Yield

(%)

Average Annual Total Return

a)

Financial Moody's Combined Bank Average

+12.29 +3.61 +15.80

Trans-portation

Bow-Jones Railroad/ Transportation Average

-2.21 +4.43 +2.22

Utility Moody Utility Average

-4.56 +5.49 +0.93

Utility. Dow-Jones Util-ity Average

-5.26 +4.98 -0.28

Other Standard & Poors1 425

+1.90 +2.94 +4.84

Other Dow-Jones Industrial Average (DJIA)

-0.26 i

+3.63 +3.37

151

sectors appear to verify the positive correlation with

dual-fund performance while t^e,utility: returns and the

moderate, return on the remaining sector seem to contradict

the above correlations. There is no relationship between

dual-fund performance an.d investment" in "Vicker' s Favorite

50" (PR10) or Dow-Jones "blue chips" (PR11).

Other portfolio characteristics are investigated.

Portfolio returns have little correlation with the number

of security investments (PRll). On the other hand, dual-

fund performance has. a strong, positive correlation to the

average dollar investment per security (PR12).

Since the dual funds were of somewhat different

initial and subsequent size, PR11 may not be as good an

indication of portfolio concentration as PR12. In line

with this finding, Sauvain suggests a larger commitment Of)

per security investment for higher returns. Similarly,

numerous authors have argued that portfolio efficiency can

be accomplished with a relatively small number of securities

(see the discussion of "portfolio theory" in Chapter III).

The most significant relationship found in the portfolio

revision analysis is the fact that portfolio performance

has a very strong negative relationship to portfolio

turnover CPR13); this relationship is significant at the 5%

20 Henry C. Sauvain, Investment Management, 4th Ed.

(Englewood Cliffs, New Jersey, 1973), pp. 367-8.

152

level. That is, the greater the portfolio turnover within

the dual-funcl industry, the lower the portfolio returns.

Jensen as wel.1 as Stauffer and Vogel found that performance

21 and turnover were negatively correlated as in this study.

On the other hand, Voorheis and Friend, et. al., found a

very small, positive correlation between turnover and

22

performance. Interestingly enough, both Voorheis and

Friend found that different sub-periods in their studies led

to different results. In the 1960-64 time period--generally

a period of rising prices--both found a negative correlation,

but both found a positive correlation for 1965-68—a period 9 3

of fluctuating stock prices.w Therefore, the strong negative

correlation found in this study may be the result of the

time period under review.

The two, best performing dual funds, ICS and GEM, had

average annual turnover of about 52% while the two lowest— 21

Michael G. Jensen, "The Performance of Mutual Funds in the Period 1945-1964," Journal of Finance, 23 (May, 1968), 417; and C. Hoff Stauffer, Jr. and Robert C. Vogel, "Parameters of Mutual Fund Performance," (Middleton, Connecticut, 1969) Wesleyan University, cited in Friend, et. al_. , ojo. cit. , go, 62.

22 Frank L. Voorheis, "Bank Trustees and Pension Fund

Performance," Financial Analysts Journal, 28 (July, 1972) 63-4; and Friend, et. al., op. cit., pp. 60, 62, 159. For another study where turnover and performance were not found to be related, see: F. E, Brown and Douglas Vickers, "Mutual Fund Portfolios Activity, Performance, and Market Impact," Journal of Finance, is (May, 1963), 386-8.

23 'Voorheis, op. cit., and Brown and Vickers/ op. cit.

153

ADV and ttkm—had average turnover of 108%. If round-turn

commission costs are figured at 2% (1% to sell and another

1% to buy) the differential portfolio turnover could have

cost the higher turnover dual funds more than 1% in gross

returns per year compared to the lower turnover (and higher

return) pair.

Portfolio Evaluation.—PE1. through PE14 are defined

as the intertemporal standard deviations of PR1 through

PR14 respectively. No distinction is made with respect

to the cause of the change leading to variability, i.e.,

variability could have resulted from market changes or

managerial changes. However, management had the opportunity

to counteract many market-related changes when it deemed

such action desirable. Therefore, these measures of

variability directly or indirectly reflect managerial

evaluation of portfolio characteristics.

Portfolio performance is strongly and negatively

correlated with both the variability of the percentage

cash and marketable securities (PE1) as well as the percentage

of common stocks (PE5). Both of these relationships are

significant at the 5% level. That is, the more that the

managers tried to shift assets to and from cash and common

stocks, the lower the portfolio performance. Since much of

the shifting to and from these asset holdings reflects

efforts at trying to adjust the portfolio in accordance

154

witheforecast m a r k e t conditions, this indicates that

the portfolio managers as a group did not do a good

job of making changes in the major mix of the portfolio.

This tends to confirm the lack of forecasting ability for

the industry discussed above as indicated by the absence of

curvature in the portfolio characteristic lines.

Performance is strongly and negatively correlated with

variability in turnover (see Ta ble XVIII). This can be

partially explained because of the impact of substantial

portfolio losses by HEM and, to a lesser extent, ADV and

PUTNC. All three of these dual funds initially pursued

aggressive, high-turnover policies. However, at the market

low point in 1970, portfolio values had declined to the

point where the preferred shareholders capital was

endangered. Therefore, HEM shifted resources to commercial

paper and short-term debt securities to prevent further

declines. ADV and PUTNC followed similar strategies

leading to a drastic reduction in portfolio turnover and,

hence, a substantial increase in the variability of -turnover.

Similarly, the shift to less risky securities increased the

variability of both cash and marketable securities (PE1) as

well as common stocks (PE5). Therefore, these portfolio

actions help to explain some of the relationships noted in

the previous paragraph.

An interesting observation from Table XVIII is the fact

that performance is negatively correlated with 11 out of the

155

first 14 portfolio evaluation variables (PE1 through PE14);

in addition, performance does not have a strong, positive

relationship to any of the other 3 (PE4, PE7, PE13) of

the first 14. That is, changes in portfolio mix, common

stock composition, concentration, or turnover, have a negative

correlation with performance. Whether changes were market-

related or management initiated, greater variability is

associated with lower returns. The results of this analysis

lend support for following a more passive type of management

such as suggested by supporters of the efficient market

24 hypothesis (EMH)."

Performance has a strong, negative correlation with the

variability of each of the continuing planning variables,

CPi through CP4; the variability of each of these variables

is given by PE15 through PE18 respectively. As discussed

above, these continuing planning (CP) variables change as

portfolio values change; however, the relationship between

performance and variability in continuing planning

variables (PE15 through PE16) is not simply the result of

changes in portfolio values. From Table XV, performance is

kiQown to be positively related to variability of returns

(and, to an extent, to changes in portfolio values).

The negative relationship between performance and variability

may be the fact that tlie more the continuing planning (CP)

24For example, see: Jensen, op. cit • , 242-5; and Lorie and Hamilton, op. cit., pp. 106-8.

156

variables fluctuated—particularly on the downside—the

more management was forced to impose additional constraints

on itself to meet its obligations. Returning to the view

of Gentry and Pike (G-P), these fluctuations led to reduced

managerial flexibility in selecting an efficient portfolio

25

and, therefore, lower potential returns.

Investigation of the individual, initial planning (IP)

variables showed little correlation with performance. The

analysis of the continuing planning (CP) variables—which,

of course, resulted from decisions made initially—showed

some relationship to performance. Here in the portfolio

evaluation (PE) analysis, further evidence exists to support

the secondary research hypothesis. That is, in efficient

capital markets, portfolio planning appears 'to have an impact

on portfolio performance (see Chapter I).

Portfolio performance has a positive correlation with

management fees and expenses (PE19) but a negative correlation

with the percentage of management fees (PE22). The former

can be ascribed to the fact ;that much of the management fees

and expenses were the annual fees (usually 0.5%) charged

against portfolio values; hence as the portfolio value went

up (positive returns) so did the management fees. The

negative correlation between performance and percentage fees

can be explained partially by the fact that there are

oq; Gentry and Pike, op. cit., 149-54.

157

substantial fixed costs to managing a regulated investment

company. As portfolio values increase, the fees and

expenses decrease as a percentage, and vice versa. The

average fixed cost for the dual-fund industry was approximately

$66,100 for the period (see Table XX); most of the variable

cost is simply the average management fee of 0.4 to 0.5% per

year. This substantial portfolio fixed cost when added to

the guaranteed dividend payments probably caused the portfolio

managers to limit the types of financial assets under

consideration—particularly following a period of declining

portfolio values. The previous discussion of the shift of

HEM's portfolio is a good example.

Multiple Regression Analysis.—The results of the

multiple regression analysis on the dual-fund industry are

shown in Ta.ble XXI. A multiple regression equation is

determined for each PMP stage as well as for the entire

26

PMP. Note that the multiple regression equations for

the initial planning (IP), continuing planning (CP), and

investment analysis (IA) stages have small and statistically

insignificant coefficients of multiple determination. Both

of the equations for the portfolio selection (PS) and

portfolio revision (PR) stages have large, multiple 26 As mentioned in Chapter II, some autocorrelation

between explanatory variables exists at each PMP stage as well as for the entire PMP. Where this autocorrelation is indicated, appropriate variables are deleted from further analysis in line with the suggestions of Nie, et. al., o|K cit., p. 341.

TABLE X£

AVERAGE PORTFOLIO SIZE MANAGEMENT FEES AND EXPENSES FOR THE PERIOD FROM MARCH 31, 1967, TO DECEMBER 31,

1973

158

Dual Fund

Average Portfolio .Size ($)*

Average, Annual Management Fees and Expenses ($)*

ADV $ 41,396,000 $ 406,200

GEM 46,186,000 397,600

HEM 24,881,000 230,600

ICS 34,060,000 255,600

LFB 56,570,000 407,000

PUTNC 25,677,000 203,400

SDV 102,943,000 733,400

fees and expenses versus portfolio size:

Ave. Mgt. Fees & Expenses(S) - $66,100 + 0.00654 x (Ave. Port. Size)

(r2 = .978)

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161

coefficients of determination, but neither is significant

at the 5% level.

The multiple regression equation for the portfolio

evaluation (PE) stage has a coefficient of multiple

determination significant at the 5% level. The equation

indicates that better performance is positively correlated

with management expenses (PE19) and negatively correlated

with: (a) the variability in the percentage of common

stocks (PES); (b) the variability in the number of portfolio

investments (PE12); (c) the variability in excess, current

portfolio yields (PE18); and (d) the variability in the use

of common stocks of public utilities (PE12). The

relationship between return and management expenses is

described above. In general, variability appears associated

with lower returns. Since the variability could result from

market changes or managerial changes, a passive management

would at least reduce the controllable variability.

Avoiding an active managerial role might then be associated

with better returns. The planning aspect of portfolio

management appears again in the form of the variability of

excess current yield (see previous discussion in the initial

regression analysis under "portfolio evaluation").

The multiple regression equation for the entire PMP is

significant at the 5% level. Performance in the dual-fund

industry during this time period is positively correlated

with concentrating dollar investment in "blue chip," Dow-Jones

162

industrial securities. Arithmetic return is negatively

correlated with the variability of investment in common

stock (PE5), the average percentage of cash and marketable

securities (PR1) and the variability in gross portfolio

yield (PE16). Some of these factors seem logical; for

higher returns, concentrate and invest in higher risk/return

securities. Efforts at timing commitments to common

stocks and different sectors within common stocks appear

unsuccessful; this corresponds to the discussion of the lack

of curvature—i.e., predictive ability in the portfolio

characteristic lines.

A word of caution must be made here. The regression

equations in Table XXI should be interpreted as descriptive

and not necessarily predictive in nature. High levels of

correlation do not mean a causal relationship exists. As

Williamson points out, interpreting regression analysis

27

depends heavily on common sense. The significant

correlations may appear due to measurement flaws, auto-

correlation that was not eliminated^: or simply by_ chance.

The PMP framework—although it is based on a substantial

theoretical and practical framework—may not represent

the actual decision-making process used in the individual

dual funds or the dual-fund industry as a whole. Therefore,

interpretation of these regression equations must proceed

cautiously. The previous discussion as well as this section

~'j. Peter Williamson, Investments: New Analytic Tech-niques (New York, 1970), pp. 279-283.

163

attempts to point out the obvious relationships which may

not be explanatory; however, the continual reappearance of

the desirability of passive management does tend to

support the efficient market hypothesis (EMH).

Summary.—The three performance measures can be used

interchangeably due to the high correlation between them.

The individual dual funds have significantly different

returns (see Tables IX and XIV). The individual portfolios

are not very efficient; thus, 3 is an inappropriate risk

measure. The appropriate risk measure, the standard

deviation around the arithmetic returns, explains about 75%

of the variation in arithmetic returns. Therefore,

performance differences exist in the dual-fund industry and

cannot be explained solely by variation in risk levels.

A series of regression equations are developed that

reflect the relationship between return and a number of PMP

variables. In general, higher performance is associated

with the use of higher risk securities, lower turnover.,, and

lower variability of portfolio mix proportions and of the

mix within the common stock categories. "Active" management

using high levels of turnover and making frequent and

substantial changes in portfolio mix proportions appears

associated with lower returns. Investment analysis, initial

portfolio selection, and portfolio revision appear to be of

lesser importance. Portfolio planning may be of substantial

importance due to the fixed nature of the portfolio management

164

cost structure and the guaranteed preferred dividends;

portfolio planning appears to be particularly important

for dual funds with, low initial performance.

The regression analysis points out several variables

that have substantial correlations with arithmetic returns.

The following section on the qualitative analysis helps

to define better the explanatory and/or descriptive nature

of some of these relationships.

Qualitative Research Results

The objective of this analysis is to provide depth and

meaning to the quantitative analysis as well as a different

perspective to the dual—fund industry. The two subsequent

sections include an analysis oi the public reports of each

of the dual funds from inception through 1973 and a summary

and analysis of the "Dual-Fund Portfolio Management

Questionnaire." The analysis of the public reports covers

the initial prospectuses and all subsequent quarterly, semi-

annual, and annual reports.

Initial Dual-Fttad Prospectuses

Table XXII lists brief statements of the investment

objectives and/or policies shown in the initial prospectuses

for the dual-fund industry. All of the dual funds indicate

that the primary—but not sole—investment media would be

common stocks. There is no statement that clearly <

distinguishes one dual fund from another. None of these

165 TABU: m i

INVESTMENT OBJECTIVES AND POLICIES FOR EUAL-FUND INDUSTRY TAKEN FRCM INITIAL PROSPECTUSES

ADV: The primary objective of American DualVest is growth of capital and. incase, and the attainment of current incane. To accanplish its goals, American DualVest will invest in securities of established companies providing continuity of dividends with the potential of earnings growth.. .The Canpany intends to invest up to 100% of the value of its total assets in cannon stocks or securities convertible into caiman stocks of companies with growth possibilities. However, when the Company's management: deems it advisable to adopt a defen-sive posture, the Coup any may invest without limit, in investment grade* non-convertible preferred stocks, bonds, debentures, notes or certificates of deposit or hold seme of its assets in cash or govern-ment securities.

GEM: The investment objectives of Gemini Fund will be current incctne aid long-term growth of both incase and capital. While these objectives •will normally lead to investment in cannon stocks, Gemini may also invest in other equity securities, and in bends, debentures, other debt securities...

HEM: The investment objectives of the Fund will be to seek long term. growth of both income and capital, consistent with providing current incane sufficient to meet the higher of the Portfolio Yield Objective or the nrim'-mnm annual $. 625 dividend requirement of the Incase Shares. Carmen stocks and securities convertible into or exchangeable for cocjEon stocks will generally constitute the rund's principal invest-ments , although the Fund may also invest in bonds, debentures and other debt securities.

ICS: The Company's investment objective is to seek long term capital ap-preciation, subject to (i) the necessity of providing for the nrin-•j'rraTm cumulative dividend requirement of the Incane Shares, and (ii) _ the requirement that, so long as the Incane Shares rasam outstanding, as to 75% of its gross assets (taken at cost), the Canpany may pur-chase only securities (except in the case of cash equivalents) having a minitriim indicated annual yield on cost of 2.75%.. .To attain its investment objective, the Canpany will invest principally in cannon stocks and other securities convertible into or exchangeable for cannon stocks. However, the Canpany is not restricted freni in-vesting in other types of securities and may invest a small propor-tion of its assets in bonds, debentures, preferred stocks, or _ other fixed-income securities when opportunities for capital appreciation in such securities exist.

166 I&BLE XXII—Continued

LFB: The investment objective of the Fund is to seek long-term growth of capital and of income consistent with reasonable current income. It will be the policy of the Fund to invest its assets in a diversified list of conncn stocks believed by it to be of high or improving investment quality, having due regard for both possible income and possible appreciation of capital.

HimC: The investment objectives of the Fund are to provide long-term growth of both capital and income consistent with current income at least sufficient to meet the annual cumulative divident as it increases periodically. In pursuit of these obhectives, it will normally be the policy of the Fund to invest in a diverisfied list of cannon stocks and convertible or other fixed income securities which appear to have possibilities for appreciation. However, the Blind reserves the right for short-term or defensive purposes to invest in fixed income securities which do not have this characteristic.

SDV: The United States has experienced long-term economic growth and a decline in the purchasing power of the dollar. Manage-ment believes these trends will continue and that the Company's assets will be more productive of income and trove likely to appreciate in value if they are invested principally in cannon stocks (and to a lesser extent convertible securities) of companies which have above-average growth prospects, rather than in non-convertible fixed-income securities... When in management's judgment, adverse business prospects or security price levels warrant, investments may be marfc in non-convertible debt securities and preferred stocks.

Source: Each "investment objective" was obtained from the initial prospectus for the respective dual fund.

167

statements is indicative of how the investment company

would actually be operated; a reader needs substantial

prescience to realize that these comparable statements would

be translated into such different approaches. However,

since the objective of the initial prospectus is oriented

more toward the legal and marketing aspects of the

organization, perhaps it is not surprising that the initial

prospectuses disclose little about how the portfolio will

be managed. In addition, from the standpoint of a potential

purchaser or analysts, these objectives and/or policies

suffer from the "ambiguity and vagueness" of expression

discussed in the section on the "Implications of the EMH"

28 in Chapter III.

Table XXIII lists the portfolio restrictions common to

all dual funds as indicated by the initial prospectuses.

Since these are common, they should not be a factor in

causing different performance. Most of these restrictions

are similar to those imposed on most regulated investment

companies. Table XXIV illustrates restrictions that are not

common to each dual fund. Inspection of Table XXIV does

not suggest any differences that could have led to any

significantly different performance.

Two dual funds, GEM and HEM, did have a distinctive

restriction not mentioned in Table XXIV.

28Lorie and Hamilton, op. cit., p. 264.

168

TABLE XXIII

INITIAL INVESTMENT RESTRICTIONS AS SPECIFIED IN ORIGINAL "PROSPECTUS"

FOR EACH DUAL FUND

Restrictions Ccmrari to All Dual-Funds

1. Purchase any security (other than government obligations) if, as a result, more than 5% of the Fund's assets (taken at current value) would then be invested in securities of that issuer.

2. Acquire more than 10% of any one class of the securities of an issuer. ., .or acquire more than 10% of the voting securities of any issuer.

3. Purchase securities on margin.

4. Buy or sell real estate or real estate mortgages.

5. Invest in the securities of other investment companies or real estate investment 'trusts (REITs).

6. Engage in the business of underwriting securities.

7. Buy or sell caanodities or ccmnodity contracts.

8. Purchase or write puts, calls, spreads, straddles, or similar devices, or engage in arbitrage operations.

9. Make loans (although this shall not prevent the purchase of securi-ties customarily acquired by institutional investors).

10. Invest in or retain securities of any company if, to the knowledge of the dual-fund, officers and/or directors of the dual-fund indi-vidually own more than %% or collectively own more than 5% of the securities of that company,

11. Invest more than 25% of the value of the assets of the fund in a single industry.

12. Invest more than 5% of total fond assets in securities of businesses less than 3 years old.

CO

Q U J l - H

g g

Purchase

Stock

Warrants?

35? as- $ I-

c? £ M £ £ £

Borrow

Money

Except

to Redeem

Senior

Securities?

No

No##

No

No

No

No

No

Repurchase

Shares?

,0 I O O l 1 t Z i Z Z i i !

Issue

Additional

Shares?

No

No

No

Purchase

Securities

to Exercise

Control

J £ 1 1 J2 £ JS 53 #3 i i f~~i £2

Purchase

Securities

Prior to

Hex-di-

dends date"

Solely for

Dividends?

No

No

No

No

No

Purclriase

Non-cash

Paying

Securities?

t \ G O l I 1 \ I 25 pH i ? i i j

Sell

Securities

"Short"?

% o % % a o o Z Z Z Z Z Z Z

Dual-Fund

Stock Symbol

p ^ | ^ w | | g

169

05

- o

0)

S

170

Both GEM and HEM had a minimum portfolio yield objective

(MYO) equal to 80 percent of the equivalent dividend yield

on the S&P 500 Composite Index. Failure to meet the

maximum of. (a) the MYO; or (b) the guaranteed, cumulative

dividend leads to a reduction in the management fee payable

to the management advisor. Table XXV illustrates the MYO

for 1967 through 1973. For the preceding eight-year interval"

(1959-1966), the S&P 500 equivalent yield was 3.14% with

the resulting MYO equal to 2.5%. The intra-period high and

low MYO ior 1959—66 was 3.02% and 2.26%, respectively.

Meeting the MYO was not much of a burden; for example,

prime commercial paper averaged about 4% during 1959-66 with

intra-period high and low of about 6% and 2.8%, respectively.29

Auuhors of initial prospectuses are torn between two

considerations. First, they must indicate the desirability

of owning the prospective securities so that the investment

company is initiated successfully. Secondly, they must create an

investment company that can be managed successfully after

it is created. The dual-fund industry accomplished the

former with different levels and timing of guaranteed

dividend payments, various management fee allocations, and

different combinations of restrictions that would presumably

provide protection to the underlying assets. The MYO appears

29 ~ "1974 Historical Chart Book, Board of Governors,

Federal Reserve System (Washington, D. C., 1974), p. 26.

171

TABLE XXV

ANNUALIZED DIVIDEND YIELD FOR S&P 500 COMPOSITE STOCK INDEX AND MINIMUM

YIELD OBJECTIVE (MYO) FOR "GEM" AND "HEM"

Year Kndipcr

Previous 4 Quarters S&P "Equivalent Dividends" to Period Ending S&P 500 CooiDosite Index

Resulting Minimum Yield Objective (MYO) for GEM- and HEM (80% of S&P 500 Yield)

1967 3.03% 2.42%

1968 2.96% 2.36%

1969 3.43% 2.75%

1970 3.41% 2.73%

1971 3.01% 2.41%

1972 2.6 7% 2.13%

1973 3.46% 2.77%

Average of Year Ending Yields- 3.14% 2.51%

172

to be a relatively desirable type of restriction from botn

a marketing and operating standpoint: the MYO has the

appearance of encouraging fiduciary actions while in fact,

it provides little effective constraint on the actual

portfolio management process. Other promises such as

minimum, guaranteed dividends are not so easily ignored

from the operating side.30 Clearly, high guaranteed

dividends enhance the saleability of the preferred shares,

but create a continuing obligation which may not be

feasible in future market conditions.

In summary, the initial prospectuses of the dual-fund

industry are not useful documents for describing the different

proposed approaches to managing the investment companies.

The prospectuses are even less useful for describing risk/

return policies that might be useful for explaining

differential performance. In line with the ambiguous and

vague description of policy, more emphasis is placed on

what management can not do (i.e., restrictions) as opposed

to what management intends to do. The requirements of the 31

various regulatory agencies seem to foster this approach.

As a result, the analysis of the initial prospectuses

provides no insight into why different performance occurred.

30For example, see: "Five 'Dual Funds'" Are Approved by SEC; Restrictions Imposed on Their Operations, ' Street Journal (March 23, 1967), 11.

31 For example, see: Gentry and Pike, op• ii*

173

S ub s e q uen t P'u a 1 - Fun d Reports

The quarterly, semi-annual, and annual reports for

each dual fund are analyzed to determine what was occurring

and why particular approaches were followed. In general,

the only method of determining what approach was followed

is through a systematic analysis of the income, position,

and portfolio change statements as well as the accompanying

footnotes. Determining "why" an approach was followed

depends on the published commentary of the officers of the

investment company; these "letters to the shareholders"

are mostly descriptive of the immediate past performance

with little if any commentary of how management intends to

deal with the forecast environments. Following is a brief

discussion that summarizes the findings of analyzing the

public reports for each dual fund.

ADV.—ADV pursued an aggressive approach in the first

several years of operation; the number of portfolio securities

was usually around 35 while Dow-Jones Industrial or Vicker's

Favorite 50 securities represented a low portfolio proportion.

Portfolio turnover averaged about 125% during 1968-70.

Convertible securities were heavily used during the first

three years averaging around 35% of net asset value CNA\).

Following the market low of mid-1970, ADV invested 25% of NAV

in cash and marketable securities because the portfolio had

shrunk to the point where the preferred shareholders capital

was endangered.

174

The portfolio management changed during 1971 (see

Table II). The only apparent difference was a reduction in

commitment to currently "popular" securities. Before the

management change, Vicker's Favorite 50 represented 21%

of NAV; Vicker's Favorite 50 average 6% after the switch Ox

rjortfolio management. Also affected was the average number

of portfolio securities—about 35 before and 30 after the

switch. Portfolio turnover averaged 125% before the change

in 1971 and 107% afterwards. This high level of turnover

persisted in spite of the fact that the shareholders approved

a change in investment policy that generally limits annual Op

turnover to 75% per year in 1970. The new management was

somewhat clearer about the portfolio strategy than the

original managersin several documents, ADV management

pointed out the desire to invest in securities of "larger, 33

established, consistent growth companies." In summary,

the public reports of ADV provide only information from

which analysts can infer what is occurring but provide

little information on why one approach is used.

GEM.—GEM was managed rather consistently over the

interval. Turnover ranged from 25% to 65%. The number of

securities was kept close to 50 from inception through 1971,

then increased to almost 70 by year—end 1973. Commitment

was always heavy in common stocks—averaging 92% and never 32"Ameri:can DualVest Fund: Notice of Annual Meeting of

Shareholders," March 30, 1970. 33"American DualVest Fund:1972 Annual Report" and

"American DualVest Fund: Three Month Report," March 31, 1973,

175

falling below 76%; convertible securities never represented

more than 6% of NAV. GEM management may have had above-

average market predictive ability because GEM increased

commitment in common stocks during market lows; e.g., the 34

portfolio was "99.7% invested on May 26 [1970] (the bottom).

The emphasis of GEM was on picking "undervalued" common

stocks with substantial underlying "value" providing a

35

"limited downside exposure." In addition, GEM management

explicitly recognized that the leveraged financial structure ' , • • , -4.- 3 6

should not be supplemented by selecting risky securities.

GEM's emphasis on "under-valued" securities included

establishing expectations and eliminating securities that <37

fail to meet expectations. GEM claimed to emphasize "concentration in specific industries and companies in an

33

effort to maximize on our investment convictions."

However, this is contradicted by the large number of

securities held throughout the period.

In summary, the periodic reports of GEM were the most

useful of the dual fund reports for explaining both what the

portfolio was trying to accomplish as well as the reasons

^"Gemini Fund: Annual Report", December 31, 1973, p. 3.

35"Gemini Fund: Annual Report", December 31, 1968. p. 5.

36"Gemini Fund: Annual Report", December 31, 1968, p. 5 07

"Gemini Fund: Annual Report", September 30, 1969.

3^"Gemini Fund: Annual Report", December 31, 1971, p. 3. Also, see December 31, 1969, "Annual Report',' p. 3.

176

lor the specific investments. The primary reason for this

superior explanatory ability is that GEM has a section

entitled "Portfolio Manager's Comments" separate from the

"Letter to Shareholders" in each annual report.

HEM.-t-HEM was managed by Gerald Tsai the best known

"go-go gunslinger" of the era. Unfortunately, the reputation

of Tsai was not sufficient to keep HEM from having the

worst performance of the dual funds. HEM was self 39

admittedly--"an aggressively-managed dual fund." Turn-

over for 1968 through 1972 averaged 146% even though the

percentage of cash and marketable securities averaged over

10% of NAV (purchase and sales of marketable securities are

not included in turnover figures). The popular, glamour

stocks (Vicker's Favorite 50) averaged 23% of NAV through

1973.

HEM attempted to time major market fluctuations by

shifting funds to and from common stocks and marketable

securities. HEM showed some initial predictive ability by-

shifting from common stocks in late 1968 and early 1969;

however, the monies were reinvested by mid-1969 just m time

for the market collapse of late 1969 and early 1970. HEM

then shifted over 55% of NAV into cash/marketable securities

after the market low point—thereby missing the really

substantial gains. After the 1969-70 effort, HEM's timing

"^"Hemisphere Fund: Annual Report, 1969',' p. 4.

177

efforts were affected by the need to protect the preferred

shareholders capital and little noteworthy ocurred.

Under the direction of Tsai, HEM used three guidelines

for selecting securities: (1) quality—quality of earning

power as evidenced by increased earnings; (2) concentration

seeking a few, well-chosen companies, and (3) marketability

—companies where capitalization is adequate to support

sizeable transactions.^ HEM maintained 40 to 50 securities

in its portfolio; so using the number of securities as a guide,

concentration did not appear to be an important guideline* How-

ever, with a small portfolio ($20-30 million) split into 40-50

securities, marketability would seem an important factor for

HEM only if turnover was expected to remain very high.

In 1973, Gerald Tsai resigned from HEM and was replaced

by another officer. The new management maintained about

48% of NAV in cash and marketable securities, doubled the

percentage of "popular" securities (Vicker's Favorite 50)

to 37% of NAV and cut portfolio turnover by two-thirds. The

general guidelines for security selection are similar to

that stated by the previous management. The new management

was operating less than one year at year-end 1973, so no

performance comparison is possible vis—a—vis the original

management.

"^"Hemisphere Fund: Annual Report, 1968," p. 4.

178

As P'F.M shifted resources to cash and marketable securities,

both the variability and volatility of returns declined

substantially. The portfolio was quite volatile from

inception through mid-1969 and again in 1971 and 1972.

The remaining time-periods substantially reduced volatility

and variability for the entire period to a point slightly

below the industry median (see Table XV). Therefore,

the computed risk level was probably far less than that

4. 4 1

desired by management.

The HEM periodic reports are of limited value in

describing why HEM took various alternatives. The des-

criptive materials sound similar to that of the other dual

funds; however, the poor performance—affected, no doubt,

by Tsai's inclination for high turnover—indicates :that

HEM was quite different. Casual reading of the periodic

reports provided few clues that any managerial approach or

resulting outcome differed for HEM.

ICS.—Like GEM, ICS was a consistently managed

company. ICS had an average of 32 securities through 1973

with a high of 35 and a low of 27. ICS made little attempt

at market timing although some common stocks were turned

into cash and marketable securities in early 1969

41Several studies indicate that the stationarity of volatility (3) is quite high for large portfolios with a substantial number of security issues Clike HEM). For example, see: Robert A. Levy, "On the Short-Term Stationarity of Beta Coefficients," Financial Analysts Journal, 27 (November, 1971), 55-62., Such studies "do not take into account the conscious changes made by management such as those of HEM.

179

(around the market peaks in late 1968 and early 1969). ICS

increased the use of convertible securities from an initial

10% to 30% of NAV by mid-1970 as interest rates rose during

the period. The common stock mix (e.g., Dow Jones Industrials,

financial, utility companies, etc) remained quite consistent

over the time period.

The periodic reports of ICS were the most austere for

the dual-fund industry. The periodic reports through 1971

have little explanatory materials on why an approach was

followed. The first quarterly report stated "growth

in earnings is the cornerstone of your management's

42

investment policy;" with that, nothing more was mentioned

about policy until the 1972 Annual Report. These periodic

reports were supplemented by a publication entitled "Trade

Winds" written by the president of the portfolio management

company. These publications were an interesting combination

of philosophy and current economic outlook; however, these

provided no insight as to specific ICS managerial actions.

The annual reports in 1972 and 1973 were more.self-contained

but only slightly more explanatory. One of the few instances

of clear investment approaches came in mid-1973 with "your

management is convinced that this is a time for bargain

hunting (in preparation for) an upward swing in security 43

pricesI' v Market prices then began a 14-month decline ending

AO

"Income and Capital Shares; Semi-Annual Report,' June 30, 1967,.

43"income and Capital Shares; Semi-Annual Report,!

June 30, 1973.

180

with prices 35% lower. In summary, the public reports of

ICS were not useful for explaining what management was

doing or why.

LFB. -LFB used a different approach to managing

a dual-fund portfolio. Initially , LFB concentrated almost

exclusively on investment-grade common stocks and used

very few fixed-income securities; LFB tried to pick a

group of high-quality securities and let the inherent

leverage create superior investment results for "both classes

of shareholders. The securities selected by LFB were

"cost-averaged"44 (i.e., buy more when price declines) and 45

LFB took over one year to become fully invested.

LFB had the largest number of investments (80) in the

dual-fund industry. The number of securities was probably

excessive since most were in the same high-quality category, 46

44"Leverage Fund of Boston; Annual Report," December 31, 1967, p. 2.

45Ibid.

4®This trend was noted in "Leverage Fund of Boston, Quarterly Report," March 31, 1969, p. 2. For theoretical discussion of this point, see: W. H. Wagner and S. C. Lau, "The Effect of Diversification on Risk," Financial Analysts^ Journal, 27 (November, 1971) 52; Guildord ,C u .BabQock, _, "A Note on Justifying Beta as a Measure of Risk, Journal of Finance, 27 (June, 1972), 702; Robert C. Kelmkosky^ . lid John D. Martin, "The Effect of Market Risk on Portfolio Diversification," Journal of Finance, 3.0. (March, 1975), 153.

181

the number of securities was gradually reduced to the 40's

by year-end 1973. At the same time that the LFB was

increasing its concentration, it; was slowly moving from

the sole emphasis on investment grade securities.

In 1967, the periodic report stated that security

investments were made in "quality common stocks carefully

selected for long-term investment objectives and not for

short-range trading purposes."47 This was still true in

1969 with a !tstrong emphasis on the stocks of companies

n48 we consider to be of investment g r a d e . . B y mid 1970,

"a more aggressive posture may be taken...this may result

49 in somewhat greater portfolio turnover." By 1972, "the

Fund's investment policy is aggressive, with portfolio

50

emphasis on...cyclical industries." The original

"Investment Objectives and Policies" was reprinted intact

in most periodic reports through 1973. By year-end 1973,

the stated policies deleted references to "investment 51

quality" and "(not) make frequent portfolio changes."

4"^"Leverage Fund of Boston: Quarterly Report," June 30, 1967.

48"Leverage Fund of Boston: Annual Report," December 31, 1969.

49"Leverage Fund of Boston: Quarterly Report," March 31, 1970.

"Leverage Fund of Boston: Quarterly Report," September 30, 1972.

C 1 "Leverage Fund of Boston: Annual Report,"

December 31, 1973.

182

In line with this change, the percentage of Dow-Jones

Industrial securities dropped from 19% (1968) to 11% in

1973 while the percentage of utilities dropped from 19%

(1967) to 8% in 1973. Portfolio turnover averaged 22% in

1968-70 and 49% in 1971-73. :

In summary, the periodic reports of LFB are useful in

describing what managerial actions were and, to a lesser

extent, the reasons for specific actions. However, the

periodic reports noted portfolio policy changes only with

a substantial lag time.

PUTNC.—PUTNC made the greatest use of convertible

securities among the dual-funds; convertible securities

averaged 38% of NAV through 1973 with a high of 53% in 1971

and a low of 18% in 1970. This use is explained in the

first quarterly report: "convertible securities...have been

used as a means of participating in...companies whose

common stocks... appear to have unusual longer-term growth

52 potentials."

PUTNC made a change to a "more aggressive investment

53

posture" in 1968 from the initial approach described as

"invested quite conservatively in high-grade common stocks

and convertible securities with relatively large holdings 52

"Putnam Duofundr Quarterly Report," September 30, 1967, 53

"Putnam Duofund: Quarterly Report/' June 30, 1968.

183

Of commercial paper."54 However, in 1969, market conditions

"necessitated a shift away from the aggressive style of

investing...[of] 1668. I [the President] regret to report

that this shift came too late..."55 Portfolio management

returned to the earlier "emphasis upon higher-grade, more 56

conservative...stocks as were held...during 1967 and 1968."

At this point, PUTNC management realized the impact of the

basic financial structure and concluded "it would be unwise 57

to magnify the risks inherent in [the structural] leverage."

This strategy remained with PUTNC through 1973. Indicative

of the strategy change is the fact that securities in the

Vicker's"Favorite 50"rose steadily from 4% of NAV in 1968

to 56% in 1973 while turnover declined steadily from the

1968 high of 176% to a low of 49% in 1973.

PUTNC made little effort at timing major market

swings. Although PUTNC increased cash and marketable

securities in early 1968 at the expense of all other types

of securities, the monies were reinvested in time to

benefit from the 1968 upturn. In early 1969, resources

were shifted into cash again from convertible securities as

interest rates continued to rise. In mid—1970, about

^4"Putnam Duofund: Annual Report," December 31, 1968.

^"Putnam Duofund: Annual Report," December 31, 1969.

56Ibid. 57Ibid.

184

one-third of the assets were shifted into money-market

instruments to "reduce the leverage of the Capital

Shares"58 and not in an attempt to time major market

swings.

In summary, the periodic reports were quite useful in

describing both what management tried to do and why they

tried various alternatives. The early reports included a

"Report of the Management Company" that defined both the

what and why; these management company reports continued

throughout most of the period. Toward the end of the time

interval, these reports were infrequent and a standard

"letter to the shareholders" became more commonplace—and

less explanatory.

SPY.—SDV was managed in a relatively consistent

pattern over the time period. Turnover averaged 34% with

a high of 53% and a low of 16%. Convertible securities

averaged 10% of NAV with a high of 19% and a low of 4%.

The number of securities increased steadily from the

initially-reported level of 44 to 109 (year-end 1970) then

decreased steadily to the high 50*s. SDV used straight,

fixed-income securities to a greater extent than other dual

funds; for example, non-convertible bonds and preferred

58"Putman Duofund: Quarterly Report," June 30, 1970.

185

59

stock represented 8.9% of NAV in 1970. SDV apparently

tried to forecast interest rate changes because the level

of straight income securities increased throughout late

1969 and 1970 as interest rates rose; this percentage of NAV

then declined in late 1970 and early 1971 as interest rates declined.

The basic approach of SDV was the selection of

"common stocks and convertible securities of companies

which management believes have prospects for above—average

growth of earnings."60 This policy was stated-In the

initial prospectus and reprinted in several reports throughout

the period. As a result, SDV did not "guarantee dividends

as did some of the other dual funds. SDV pointed to the

fact in the initial prospectus that dividend income in the

first few years would not be adequate to meet the dividend

on the preferred shares and dividend arrearages were anticipated

in the first few years. This arrearage eventually reached

$.42 per income share in September, 1969. The existence of

the dividend arrearage had no noticeable impact on portfolio

management.

59Unlike some of the other dual funds that used straight fixed-income securities to protect asset values (e.g., ADV and HEM), SDV apparently used this investment instrument to provide some portfolio diversification. For a discussion on this subject see: W. F. Sharpe, "Bonds versus Stocks: Some Lessons from Capital Market Theory," Financial Analysts Journal, 29 (November, 1973), 74-80.

60"Scudder Duo-Vest: First Quarterly Report," June 30,1967,

186

SDV made some successful efforts at timing market

movements. Common stocks were sold and the funds used to

buy cash and market securities in late 1968 and early 1969

(market highs); the cash and equivalents were increased

throughout 1969, reaching a high of 23% in mid-1970 (market

low). Thus, SDV was able to protect some of its principal

values from decline. The funds were reinvested until 1973

when both fixed and variable income securities were sold

and the monies reinvested in money-market instruments.

Cash and marketable securities averaged 16% throughout 1973,

thereby protecting asset values during the 1973 decline.

In all, SDV illustrated a significant ability to time market

swings;61 however, this ability is not confirmed by the

earlier quantitative analysis (see the discussion of

curvature of the portfolio characteristic lines).

In summary, the SDV reports do not provide useful

material for describing why management pursued specific

actions. The "Letter to the Shareholders" was mostly

descriptive of recent past economic and market action, with

some future forecast conditions mentioned. Like some of

the other dual funds, SDV management was not specific

enough to define how they intended to react to these forecast

conditions.

rfna"l~fund industry snoweu uuabu ---— -

t i v e s ^ D i v e r s i f i c a t i o n , ^ i s / a ' "

Financial Analysts Journal,31 (March, 1075), 43 4.

187

Summary.—In general, the periodic reports of the dual-

fund industry do not provide adequate information to

determine what management intends to do or why.

position, income, and change of position statements create

a base for analysts to infer what happened, hut the des-

-i-iTT incnfficient to describe why. oriptive materials are usually insufficient

The periodic reports suffer from the same "vagueness and

ambiguity" in objectives, policy, and strategy that has been

discussed before (see the discussion in Chapter III).

Some of the periodic reports are .uite useful in describing

what and why, e.g., GEM and PUTNC; others are not. Almost

all suffer from a substantial time lag between change in

policy and notification of change. The periodic reports of

most dual funds became less descriptive over time

therefore, less explanatory.

It is not surprising that the published reports of the

i-i+tip insight into the what dual-fund industry provide so little g

and why of portfolio management actions. This is not the

function of these reports; like initial prospectuses,

periodic reports serve a legal function primarily and public

r6l&tions socond&rily.

In this and the preceding section, descriptive

materials are presented that illuminate some of the quantit-

ative results. In the previous section, the initial

prospectus provides .information on the initial portfolio

planning stage. The periodic reports provide information

188

for analyzing the portfolio selection, revision, and

evaluation stages as well as the investment analysis stage

to a lesser extent. From this discussion, many of the

quantitative variables become more meaningful, e.g.,

variability in portfolio turnover, portfolio composition,

etc. The initial and periodic reports require substantial

interpretation of managerial actions; what is needed is

a more direct interaction with management to better analyze

the portfolio management process. The portfolio

management questionnaire discussed in the next section deals

with this need for more direct interaction with portfolio

decision makers.

Portfolio Management Questionnaire

The portfolio management questionnaire was sent to

thirty-eight managers and corporate officers who were

affiliated with the various dual funds from inception

through 1973. A sample questionnaire is illustrated in

Appendix C. Seven (7) questionnaires were completed and

returned; two responses came from SDV (hereafter, referred

to as SDV CI) and SDV (II)) and one each from the other

dual funds except GEM. Mr. John Bogle, President of The

Wellington Group of Investment Companies, declined to

respond to the questionnaire because of the significant

intrusion on the time spent on the Fund's [GEM]investment

189

activities."62 Mr. Bogle commented on the questionnaire

by saying "your detailed questionnaire...would take

literally hours to answer adequately. If this is true,

the detailed nature of the questionnaire may help to

explain the realtively low response rate.

The responses to the portfolio management questionnaire

are given in Appendix E. Summarizing the results of the

questionnaire is quite difficult due to the substantial

variability in the quality of responses. As mentioned

above, no responses were received from GEM; the one response

from ADV was quite brief. On the other hand, the responses

from SDV (I) and SDV (II), and from a PUTNC manager were

quite extensive and were frequently supplemented by other

documents. Because of the variability of responses, the

results will be presented in an abbreviated form.

The responses to questions 1 through 4 indicate the

concern for the initial marketing of the shares and the

"extras" promised by the dual funds in terms of escalating

dividends and/or escalating preferred share redemption

prices. Neither the LFB nor SDV respondents voiced any

concern about initial marketing and neither used "extras".

Both ADV and PUTNC indicated concern over initial marketing

6^Letter from John C. Bogle, President The Wellington Group of Investment Companies, June 28, 1974.

6 3 Ibid.

190

and both- promised "extras." This raises an interesting

question about the role of the investment banking syndicate

on investment company structure and the resulting

relationship to portfolio performance.

Questions 9 through 17 deal with the investment analysis

stage of PMP. The industry depended heavily on internally

generated, fundamental research that was split about evenly

between broad economy-wide research and more specialized

research. All but LFB aimed the research at developing

"BUY, HOLD, SELL," lists. All claimed that explicit interest

rate forecasts were used as a basis for portfolio decisions.

Portfolio evaluation is dealt with in Question 2o

through 32.64 HEM—the lowest performing dual fund—was the

only respondent that did not have a formal system of compar-

ing BUY-SELL recommendations with actual results. Only LFB

and PUTNC calculated portfolio volatility (3); this lack of

use of M s a portfolio performance measure is probably

justifiable since the portfolios were not efficiently

diversified (see discussion of portfolio characteristic lines).

The dual funds follow a wide array of market indices but

follow a more limited number of measures of market current

yields; given the concern with income-generating ability,

64Tn earlv 1967, investors were aware of the disadvantage of buvin-- a closed-end investment company that might sell at a discount after initial issue; to overcome ^ new investment companies often felt obliged to o B „ "twist." For a discussion of this subject, see. Never Buy a New One," Economist, 249'(November 10, 1973), 142-3.

191

this fact is somewhat surprising.

Portfolio strategy/policy/philosophy changes are

discussed in Question 32. The responses of HEM confirmed

the conclusions reached in the previous section concerning

shifts into cash/marketable securities to protect remaining

asset values. The LFB response denied any change when, m

fact, a significant change occurred from initially holding

a large number of high-quality issues.

Questions 34 through 41 deal with the organizational

structure of the portfolio management company. The

responses were not adequate to categorize the seven dual

funds in the taxonomy suggested by Crerend and Broom

(See Chapter III and Table V).6b The two lowest-performing

dual funds, ADV and HEM, indicate no plan for staffing the

portfolio manager position until termination date. Of the

respondents, only ICS indicated that it had no formal policies

on research, strategy, trading, cash management, etc.

When asked about the quality of management, only ADV

mentioned "Below Average," HEM and ICS respondents ranked

their organizations "Above Average" while PUTNC and SDV

ranked their organizations as "Outstanding." There is no

apparent correlation between perceived quality of organ-

ization and portfolio performance (See Table XXVI).

®^William J. Crerend and Edward Broom, "A Taxonomy of Money Management," Financial Analysts Journal, 30 (May, 1974), 24-30+.

192

TABLE XXVI

(TMPARISON OF PERCEIVED OEGA^IIZAIICNAL QUttJT? VERSUS PERFC®1ANCE WITHIN DUAL-FUND INDUSTRY

Dual fund

Perceived "Organizational

Quality" _ Industry Banking

bv Geometric Return

Were Gross Returns Greater than S&P

500?

ADV Below Averse 6 No

GEM No Response 1 Yes

HEM Above Average 7 No

ICS Above Average Yes

LFB No response 4 No

puinc Outstanding 5 No

SDV Outstanding 3 Yes

NOTE: There re no responses of "Far Below Average" or "Average " SS oeSo^ca 3 the no dual funds -Aose «spondmts priced "Above Average" included funds mtn performance at both a® top and bottom of the industry. The perrormsnce of the ™ funds whose respondents marked ' 'Outstanding included pe.i.or-wgnrp "both above and below the industry median.

193

In summary, the questionnaires are quite interesting

and are useful ior reaffirming some of the conclusions

derived from studying the periodic reports. The low

response rate makes summary and/or comparison difficult.

However, there is no evidence that the material gathered

in this questionnaire helps to explain differences in

performance in the dual-fund industry.

There are two possible reasons: First, the questionnaire

may not be an adequate instrument for describing decision-

making as it occurred throughout the dual-fund industry;

secondly, there may not be any material that could help

describe the causes of differential performance simply

because none exists. The first case seems inappropriate

because the questionnaire was devised on the basis of previous

research; if any problem exists with the questionnaire, it

is that the questionnaire is too "detailed" and discouraged

respondents. The second reason may be closer to explaining

the lack of differentiating material. In line with the

efficient market hypothesis (EMH), most of the return (75%

for the dual funds) is explained by differential risk. This

leaves only 25% unaccounted for and the analysis of the

portfolio management questionnaires may not be a sufficiently

sensitive technique to be able to explain such a small

amount of differential performance.

194

Summary

The performance within the dual-fund industry varies

widely. The statistical testing of the dual-fund industry,

inter-year performance rankings (see Table XI) indicates a very

weak dependence over time. THat is, the year-by-year performance

of the dual funds had a very slight correlation within the

industry. Aboiit 75% of the variation in the arithmetic

return for the dual-fund industry is explained by variation

in the level of risk accepted. The dual funds were not

well diversified from inception through 1973; therefore, the

variability of returns is the appropriate risk measure, not

the volatility of returns (8). The portfolio characteristic

lines do not indicate any ability on the part of any of the

dual funds to predict market trends successfully.

The analysis of performance versus variables representing

each of the portfolio management processes (PMP) stages

yields several interesting results. In general, "passive"

management is characterized by lower portfolio turnover,

lower variability in portfolio mix among types of financial

assets, or lower variability in the levels of common stock

classifications. "Passive" portfolio management is apparently

associated with better performance within the duatfund industry

during the time period under review, this may be due to one or

more combination of reasons. First, the "better"managers may

have correctly perceived the markets and, therefore, had to

195

do much less adjusting.66 Secondly, the efficient market

EMH proponents argue that most portfolio activity is wasted;

therefore, "superior" management is "passive" management.

The quantitative results generally support the EMH.

The investment analysis, portfolio selection, and portfolio

revision stages show no significant impact on performance.

Portfolio evaluation has a significant relationship to

performance but much of this relationship results from the

arbitrary assignment of portfolio variability measures to

this stage. The analysis of the periodic reports and the

portfolio management questionnaire helps to explai

significance of many of the portfolio evaluation stage

variables.

The initial planning and continuing planning stages

show little quantitative relationship to performance that

is not merely the result of changes in portfolio values and,

hence, current portfolio returns. The question is raised

of the burdens placed upon the portfolio managers by the

"extras" that the underwriters may have felt were needed

to market the company initially. Although no significant,

quantifiable relationship is found in this research, the fact

~ s 6W,r a discussion of "procrustean thinking" in investment policy see: Harry C. Sauvain, Problems of •pnT.+ fn-i i x>ni i r.v" . Financial Analysts Journal^,

(Say 1965, , - 8 9 - G S m T T s a i . s « ^ ^ ft S 0 T n t 0

have been an example of trying to lit eveiy p the same preconceived viewpoint.

196

that the two of the three best performing dual funds-GEM

and SDV—have no "extras" while two of the lowest three-

ADV and POTNC—have extras appears to be more than

coincidental.

The initial planning appears far more important when

the best three dual funds (ICS, GEM, and SDV) are recognized

as the three most consistently managed. That is, the

"successful" managers established a policy and stuck with

it whereas the other four dual funds all had substantial

policy changes over the time interval. It is impossible

to prove whether the top three were actually "better" or

just "luckier"; the policies of the top three turned out to

be relatively successful so no change was needed. The

policies of the others were perceived as inadequate, so

these were changed. Although there is no demonstrable

quantitative proof, the portfolio planning stage still

appears to be a prime candidate for explaining a substantial

part of the performance that remains unexplained «,fter

adjusting for different risk levels.

Variability of such portfolio characteristics as

turnover, major mix, etc., is assumed to be a measure of

the portfolio evaluation effort. As discussed in Chapter

III, variability can result from managerial actions or

market actions; in either case, portfolio management has the

opportunity for affecting the variability if it desires.

The results of the analysis of the periodic reports indicate

197

that much ol the variability results from changes in manage-

ment policy relative to market trends, industry/company

outlook, etc. Hence, much of the activity of the dual-

fund portfolios occurred because management felt it had

better predictive ability than the market as a whole.

Higher dual-fund performance is associated with lower

portfolio activity; the assumption held by the more active

portfolio managers that they had superior predictive ability

appears unsubstantiated. That is, the experience of the

dual-fund industry as a whole tends to support the

efficient market hypothesis.

CHAPTER V

CONCLUSIONS AND RECOMMENDATIONS FOR FUTURE RESEARCH

This final chapter is broken into two sections. The

first summarizes the results of the research effort and

presents the conclusions. The last section discusses

possible extensions of this research for future study.

Summary and Conclusions

This research can be viewed as a systematic, in-dep^h

empirical test of the strong form of the efficient market

hypothesis (EMH) using the dual-fund industry as the

research subject. Unlike most of the strong form EMH

research, this study deals with a small, homogeneous sector

of the investment company industry with a comparable origin

date. To obtain homogeneity of the research subjects, the

sample size is necessarily smaller, thus, making difficult

finding statistically significant results.

Y/ithin the framework of general systems theory (see

Chapter I) and the view of management as a process, the

portfolio management process (.PMP) is developed (see Chapter

III). The PMP evolves from several other attempts at

systematically defining the management of sets of financial

assets (see Figures 7, 8, 9 and Tables I and VII). The

PMP is used as a framework for systematically analyzing

198

199

the portfolio management in the dual funds. Like other

efforts at viewing management as a process, th.e PMP

framework suffers from the difficulty in defining precisely

where every function and managerial task falls within the

various PMP stages. However, the PMP is extremely useful

as an analytic framework for defining and categorizing

managerial actions of different portfolio managers.

The analysis of the dual funds shows substantial

variation of performance; this variation holds true

whether average arithmetic return, geometric return or

risk-premium-to-variability is used as the performance

measure. The inter-year rankings within the dual-fund

industry show a very slight dependence over time (this

correlation is only significant at the 25% level). Analysis

of the portfolio characteristic lines indicates that two of

the dual funds (ICS and GEM) generated returns greater

than that predicted by the capital asset pricing model (CAPM)

Three other dual funds generated returns less than that

predicted by the CAPM. No non-linearity is found in any of

the portfolio characteristic lines indicating that no dual

fund had consistently superior or inferior market predictive

power during the time period under review.

About 75% of the variation in returns of the dual-fund

industry is explained by variation in risk (see Table XV).

Since the dual funds were not well diversified during the

200

interval from inception through 1973, the variability of

returns and not the volatility of returns (B) must be used

as the relevant risk measure. In addition, the volatility

of returns (6) for some of the dual funds, e.g., HEM,

varied over the time period due to changes in portfolio

policy. The management of the dual funds did not use 3

widely as a risk measure.

The regression analysis shows interesting results.

Arithmetic returns are significantly and negatively

correlated to the percentage investment in cash and

marketable securities, portfolio turnover, the variability

in the percentage cash/marketable securities, and the

variability in the percentage of common stocks. The level

of convertible securities—an investment media widely

suggested for the dual-fund industry—has no correlation

with arithmetic return.

The multiple regression analysis is used to develop

statistically significant multiple regression equations

for the PMP and its stages. No significant anelationships

are: found for the initial portfolio planning, continuing

portfolio planning, investment analysis, portfolio

selection, or portfolio revision stages. Significant

multiple regression equations are developed for the

portfolio evaluation stage as well as the PMP as a whole.

The portfolio evaluation stage has a significant relationship

primarily due to assigning all measures involving the

201

variability of portfolio characteristics to this stage.

In general, portfolio performance is negatively

correlated with variability in measures of portfolio

characteristics such as the major mix, common stock

categories, portfolio turnover, etc. The better-performing

dual funds were more consistently managed while the lower-

performing companies had significant and sometimes frequent

changes in portfolio policies. The management of the

better performing funds may have perceived the future

correctly or may have been "lucky." Analysis of the

periodic reports fails to find any dual fund with consistent

foresight in market predictive ability. In line with the

efficient market hypothesis, "passive" management, i.e.,

low turnover, few changes in major mix or common stock

composition, etc. , shows better results in the dual-fund industry


The qualitative analysis assists in describing why

portfolio management followed certain policies. The

initial prospectuses are not particularly useful for

describing what the investment companies intended to do;

policies were generally vague and ambiguous. Emphasis of

the initial prospectuses is on what management could not do

as opposed to what management intended to do. The periodic

reports suffer from describing what happened in the past

reporting period as opposed to why management followed a

particular approach. The ability of the periodic reports

202

of the different dual funds to describe what approach was

followed varies greatly. The periodic reports of almost all

of the dual funds suffer from a time lag between policy

changes and notification of policy change; the periodic

reports of most of the dual funds become less explanatory

over time.

The initial prospectuses and periodic reports were

not sufficient to describe the causes of differential

performance because little is expressed about the nature of

the management process within the portfolio management

company. The "Portfolio Management Questionnaire" is

designed to fill in the gap about how the dual funds were

actually managed. The variability in the quality of

responses received from six of the seven dual funds made

interpreting the results difficult. In general, the

questionnaire results confirm the conclusions developed from

the analysis of the initial prospectuses and periodic

reports. The initial prospectuses, periodic reports; and

portfolio management questionnaires are individually

inconclusive; collectively, they provide substantial

background and meaning to the quantitative results.

The Research Hypotheses and Relevant Conclusions

The primary research hypothesis given in Chapter I is

as follows:

203

The portfolio management process directly and mater-ially effects portfolio performance. Further, differential portfolio performance can be explained by a systematic analysis of the parts as well as the whole of the portfolio management process.

The secondary research hypothesis states that:

In relatively efficient security markets with highly trained and motivated participants, differential portfolio performance is primarily determined by the initial stage of the portfolio management process, the portfolio planning stage.

As discussed before, 75% of the variation in returns within

the dual-fund industry is the result of different levels of risk

accepted. Since risk acceptance is an important component of

the portfolio planning stage (see Table I), the first sentence

of the primary research hypothesis as well as the secondary

research hypothesis necessarily holds true by definition.

The portfolio management process (PMP) provides a useful

framework for systematically analyzing both the quantitative

and qualitative aspects of portfolio management in the dual-fund

industry. In spite of the systematic and vigorous study into

the performance of the dual-fund industry, the results generally

support the efficient market hypothesis (EMH) and the capital

asset pricing model (CAPM). That is, systematic analysis of the

PMP does not explain conclusively differential performance in

the dual-fund industry except that differential performance

associated with the differential risk accepted.

After taking into account the relationship between risk

and return discussed above, the secondary research hypothesis

is generally unproven. Portfolio performance is not shown

204

to be significantly related to the measures representing

investment analysis, portfolio selection, and portfolio

(revision. Some of the' significance indicated for portfolio

evaluation could have been attributable to portfolio

revision because of the arbitrary assignment of variability

measures to portfolio evaluation instead of revision.

The fixed cost nature of the management expenses as well as

the fixed nature of the guaranteed dividends should have

had an adverse impact on those funds that performed poorly

initially (e.g., HEM) as Gentry and Pike predicted.1

Therefore, portfolio planning should have had a significant

impact on performance in the industry. The very weak i:

correlation of the inter-year performance rankings tends

to support this, however, the empirical evidence from this

research does not prove this point conclusively.

The fact that "non-active" management is associated

with better performance in the dual-fund industry can be

attributed to one of at least three factors: (1) luck;

(2) efficiency of the capital markets; or (3) the superiority

of the initial investment counseling that permitted adaptation

to varied investment climates without radical policy change.2

1 James E. Gentry and John R. Pike, ''Dual Funds Revisited," Financial Analysts Journal, 24 (March, 1968), 149-57.

2For an excellent discussion of the role of investment counseling leading to an appropriate investment policy in efficient capital markets see James E. Lorie and Mary T, Hamilton, The Stock Market (Homewood, Illinois, 1973), pp. 260-6

205

The author tends to support the last alternative as it

pertains to the dual-fund industry particularly when comparing

the best three performing dual funds, ICS, GEM, and SDV, to

the worst two dual funds, HEM and ADV. Two factors support

this viewpoint. First, the management of the better

performing funds seemed more able to see the problems of

managing this type of portfolio; this may be reflected in

the fact that two of the best three dual funds offered

no "extras" to enhance the initial marketing while two of

the lowest three did offer initial "extras." Secondly, the

strong, negative relationship between performance and the

variability of the continuing planning (CP) variables lends

strength to the assertion that the better performing dual

funds had better overall planning and less need for

substantial change.

Recommendations for Future Research

The large and expanding body of published research

into the management and performance of sets of financial

assets discourages this author from recommending extensive

further research in this area. The efficient market hypothesis

(EMH) indicates that additional study of the securities

transacted in the capital markets yields small incremental

benefits; similarly, the benefits from studying the efficiency

of the capital markets is probably quite small following two

decades of intensifying research.

206

Much of the research in this area deals with the

statistical analysis of large numbers of portfolios with the

hope of finding "superior" management. When none (or very

few, at best) are found, some authors are inclined to

conclude that management is not important in efficient markets,

Little research has focused on the actual portfolio management

process—as this research does—with the view of trying to

find what characteristics if any, effect performance. One

reason this approach may be ignored is the lack of access

to a sufficiently large number of homogeneous investment

companies where enough factors are held constant to permit

an investigation of the effects of other variables.

As discussed in Chapters I and III, the dual-fund

industry is an excellent example of a homogeneous segment

of the managed portfolio universe. As such, the dual-fund

industry warrants further analysis. The first dual-fund

to voluntarily liquidate is not scheduled to do so until

1979; therefore, several more years exist for study of the

entire, original industry. Since the industry is numerically

small, longer periods of analysis and study are needed to

provide more validity to conclusions.

Several interesting areas of research remain. First,

a continuing analysis of the correlation over time of the

intra-industry performance rankings seems warranted. The

very slight correlation shown in Chapter IV may persist or

may disappear; this has substantial EMH implications. If

207

the weak correlation persists or strengthens, this would

tend to refute the strong form of the EMH; a decline in the

inter-year correlation would support the hypothesis that

market participants do not have access to relevant infor-

mation from which consistently superior performance can be

obtained. Secondly, as the number of years under study

increases, analyses of sub-periods, e.g., first five

years versus second five years, etc., may show interesting

results. The third area is related to this; a continuing

analysis of the curvature of the portfolio characteristic

lines may indicate market predictive ability for certain sub-

periods. For example, the constraints imposed by the initial

"extras" may have reduced the initial flexibility to apply superior

market predictive ability. Therefore, one hypothesis might

be that the curvature of the portfolio characteristic lines

may increase over time. Another alternative hypothesis is

that the curvature changes during bull (up) or bear (down)

markets.

Certain other points arose in this research that might

suggest future lines of inquiry efforts. For example,

turnover is shown to be significantly and negatively related

to performance. Therefore, a fourth area of study could

be investigating the relationship between performance and

turnover for different sub-periods. Chapter IV points out

the fact that several researchers found different relation-

ships between performance and turnover for different

208

sub-periods.3 A fifth area of research would be an analysis

of turnover in the dual-fund industry versus market trends.

Brown and Vickers found a positive relationship between

portfolio turnover and upward movements in general stock

prices.4 Analysis of the dual-fund industry may provide

further insight into this area.

The discrepancy between the results of the two measures

of portfolio concentration, PR12 and PR13, indicates that

potential need for an improved measure of concentration.

Rosenberg suggests a concentration index developed by

"dividing the ratio of the holdings in a firm to total

portfolio holdings...by the ratio of the market value of the *3

firm to the market value of all firms..." A simpler

measure of concentration is the proportion of total net

asset value (NAV) held in the largest five, ten, or twenty

holdings. Study of either or both of these variables may

lead to clarification of the effect of concentration on

performance, if any. 3For example, Frank L. Voorheis, "Bank Trustees and

Pension Fund Performance," Financial Analysts Journal, 28 (July. 1972) 63-4; and Irwin Friend, Marshall Blume, Jean Crockett, Mutual Funds and Other Institutional Investors (New York, 1970), pp. 60, 62, 159.

4F.E. Brown and Douglas Vickers, "Mutual Fund Portfolio Activity, Performance, and Market Impact," Journal of Finance, 18 (May, 1963), 383.

5Marvin Rosenberg, "Institutional Investors: Holdings, Prices, and Liquidity," Financial Analysts Journal, 30 (March, 1974), 54-9.

209

A seventh area for future study would involve develop-

ment of a measure of the "quality" of a portfolio. As

mentioned in Chapter II, no simple, quantitative measure of

quality has yet been developed for a portfolio of financial

assets. Wagner and Lau suggest the use of Standard and

Poor's Earnings and Dividend Rankings; however, these

authors do not attempt to develop a measure for sets of C\

differently-ranked securities. A portfolio quality measure

using both bond and/or stock ratings might be feasible.

Last, this research did not deal with diversification based

on categorizing securities as domestic, foreign, or multi-

national. Solnik indicates that international diversification 7

may well be easier than domestic diversification. If this

is so, a hypothesis could be tested to see if the existence

or level of international diversification of securities is

associated with better performance.

Analysis of the impact of the portfolio management

process (PMP) in the dual-fund industry is hindered by two

main factors: (1) the industry buys and sells assets

in markets that are quite efficient; and (2) the industry

is numerically small. Future research into the impact of

®W.H. Wagner and S. C. Lau, "The Effect of Diversification on Risk," Financial Analysts Journal, 27 (November, 1971), 4g. _

^Bruno Solnik, "Why Not Diversify Internationally Rather Than Domestically?" Financial Analysts Journal, 30 (July, 1974), 48-52.

210

management on performance could be shifted to the real

estate investment trusts (REITs) or the closed-end bond

funds. The REITs deal with assets bought and sold in

markets that are probably less efficient than corporate

securities markets; similarly, the closed-end bond funds

deal in financial assets whose secondary markets are somewhat

8

less active than the secondary markets for common stocks.

There are over twenty-five major REITs and most were

begun during 1969-71 (see Table XXVII). Also there are

over twenty-five closed-end bond funds begun in the 1973-74

time period.^ The larger number of REITs and closed-end

bond funds would be helpful for statistical hypothesis

testing while comparable start dates would ensure that

performance is analyzed through similar market environments.

A study of the PMP in the REIT and closed-end bond

fund industry could proceed in a fashion parallel to

this research. Emphasis could be placed on the planning

stage and, in particular, on the impact of the underwriters

on the initial organizational structure and initial portfolio

restrictions. A discriminant analysis of the impact of

initial portfolio constraints on performance could be quite

^Jerome B. Cohen, Edward D. Zinbarg, and Arthur zeikel, Investment Analysis and Portfolio Management, Revised Edition, (Homewood, Illinois, 1973), p. 60.

^"Wiesenberger Investment Companies Service," Wiesenberger Services, Inc., New York, New York, 1976, p. G-3.

211

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CD 4^ S={ !-H

*H T5 )H U 3 CD CD bo

. rH 0 d

0 S3 0)

CD CS Bs 0) 0) •H

55 ^

CD o

o CO

212

interesting. However, the effect of management on the

performance of the REITs is somewhat blurred by the fact

that the REIT managers are responsible for both asset and

liability management whereas the dual-fund managers are

essentially asset managers. In spite of this factor, the

quantitative and qualitative research performed in this

study on the dual-fund industry could be virtually repeated

in both the REIT and closed-end bond fund industries.

APPENDIX A

PORTFOLIO CHARACTERISTICS AND MEASURES

DEFINITIONS AND MATHEMATICAL FORMULAS

214 PORTFOLIO CHARACTERISTICS

PORTFOLIO PLANNING (Initial)

Management Fee (%) — IP1 IP1 •» annual fee charged against portfolio NAV (%)

Initial Minimum Cash Portfolio Yield (%) ~ IP2 LP2 » Total $ Initial "Guaranteed" Dividends

Initial Portfolio NAV

Average Minimum Cash Portfolio Yield (%) — IP3 /Total $ "Guaranteed" Dividends over Life of Dual Fund

£P3 M Number of Years of Life for Dual Fund Initial Portfolio NAV

Average Required Return to Fund Termination (%) — IP4 /Annual Amortized Difference Between Initial \

IP4 = IP3 +f Preferred Price Paid to Dual Fund and Amount 'Dual Fund Premised at Termination / ~~ Initial Portfolio NAV :

NOTE: ADV intends to pay $1.20 more per share to preferred shareholders than original, paid-in capital

ICS intends to pay $0.85 more per share to preferred shareholders than original, paid-in capital"

PUINC intends to pay $1.51 more per share to preferred shareholders than original, paid-in capital

Initial Minimum Cash Portfolio Return (%) — IPS /Pro Rata \

I?5 = Share of x IP1 + IP2 + 0.2% Fee*/

Average Minimum Cash Portfolio Yield (%) — IP6 /Pro Rata \

IBS » Share of |x IP1 + E?3 + 0.2?; \Mgt. Fee*/

Average Required Return Until Fund Termination (%) —. IP7 / Pro Rata \

IP7 = Share of X IP1 + IP4 + 0.2% \Mgt. Fee*'

*GEM and HEM each charged: 50% of management fees and expenses against the capital shares; and 50% of management fees and expenses to income shares (i.e., against portfolio income)

Maximum Planned Portfolio Size ($) ~ IP8

IPS = Maximum $ Size Shown in Initial Prospectus

x 2 x 100%

215

PORTFOLIO PLANNING (Continuing)

Interest as a Percentage of Portfolio Income (%) — CP1 | Total Gross Interest Earned for Period \ x 100%

CP1 =' Total Gross Portfolio Income for Period /

Average Annual Gross Portfolio Yield (%) — CP2 /Gross Portfolio Income for 6 Months ix 2 x 100%

CP2 Period-Ending Portfolio Value ' »

Average Annual Required Minimum Current Yield (%) — CP3 Required Sani-Annual Total Preferred Share Divi-\ j dends Plus Management Expenses Cnarged Against

CP3 Incctse for 6 Months

Period-Ending Portfolio Value

Average Annual Excess Current Yield (%) — CP4

GP4 = CP2 - CP3

INVESTMENT ANALYSIS Average Percentage of Portfolio in Vickers Favorite 50 (%) — IA1 (same as PR10)

/Total Period-Ending Value of Cannon Stocks and\ | Securities Convertible into Canron Stocks that

IA1 =* were Listed on Vickers Favorite 50 /x 100% Total Period-Ending Net Asset Value

Average Percentage of Portfolio in Dow Jones Composite Stock Average (%) — IA2 (same as PR11)

/Total Period-Ending Value of Coirnxn Stocks and\ Securities Convertible into Cannon Stocks that

IA2 ="were Listed in DJ CocnDosite Average /x 100% Total Period-Ending Net Asset Value ~

Average Percentage of Senior Securities (Preferred Stocks and Bends) to Net Asset Value (%) « LA3 (same as FR2)

/Total Period-Ending Market Value of Preferred) IA3 =1 Stocks and Bonds I x 100%

Total Period-Ending Met Asset Value

PORTFOLIO SELECTION/REVISION

NOTE: Variables PS1 through PS13 have the same definitions as PR1 through PR13 except that all PS variables show the portfolio position as reported in the first public report and all PR variables show the average portfolio position from inceotion through 1973.

216

Initial/Average Cash and Marketable Securities to Net Asset Value Oo) — PS1/FR1

/Net Period-Ending Cash Plus Short-Term \ PS1/PR1 Marketable Securities | x 1007=

'Total Period-Ending Net Asset Value /

Initial/Average Senior Securities (Preferred Stocks and Bonds) to Net Asset Value (70) — PS2/PR2 (PR2 same as IA3)

/Total Period-Ending Market Value of \ PS2/PR2 = 1 Preferred Stocks and Bonds _____ x 100%


Initial/Average Convertible Securities to Net Asset Value <%) — PS3/PR3

/Total Period-Ending Market Value of Convert-\ PS3/PR3 =iible Preferred Stocks and Bonds x 100%


Initial/Average Senior Securities and Carman Stocks of Publically-Regulated Utilities to Net Asset Value (%) — PS4/PR4

^ Total Period-Ending Market Value of Preferred / Stocks, Bonds and Common Stocks of Regulated 1 Industries such as Public Utilities, Tele-

PS4/PR4 phone co's (excluding TIT) /x 100%, Total Period-Ending Net Asset Value

Initial/Average Cannon Stock to Net Asset Value (%) — PS5/PR5 /•Total Period-Ending Market Value of Cotmm\

PS5/PR5 =( Stocks and Caixton Stock Warrants x 100% \Total Period-Ending Net Asset Value /

NOTE: PS1 + PS2 + PS5 = 100% PR1 + PE2 + PR5 - 100%

Initial/Average Percentage of Financial Carmen Stocks and Securities Convertible Into Cannon Stocks (7,) — FS6/PR6

/Total Market Value of Camion Stocks and \ [Securities Convertible Camion into Stock

PS6/PR6 = \of Financial Companies / x 100% jTotal Market Value of Cannon Stocks and 1 . 'Securities Convertible into Camion Stock!

Initial/Average Percentage of Transportation Cannon Stocks and Securities Convertible Into Cannon Stock (%) — PS7/PR7

/Total Market Value of Cannon Stocks and \ Securities Convertible into Stock of

PS7/PR7 -'Financial Companies I x 100% fTotal Market Value of Cannon Stocks and \ 'Securities Convertible into Cannon Stock1

217

Initial/Average Percentage of Utility Cannon. Stocks and Securities Convertible Into Cannon Stock (%) — PS8/PFJ3

/Total Market Value of Conmon Stocks and Securities Convertible into Conmon Stocki

PS8/PR8 =\of Regulated Utilities / x 3.007® (Total Market Value of Camion Stocks and\ ' Convertible into Common Stock '

Initial/Average Percentage of all Other Cannon Stocks and Securities Convertible Into Cannon Stock (%) -- PS9/PR9

PS9/FS9 » 1007. - PS6/PR6 - PS7/FR7 - PS3/PS8

NOIE: PS6 + PS7 + PS8 4- PS9 — 10C%> PR6 + PR7 + PRS + PK9 = 100%

Initial/ Average Percentage of Vickers Favor late 50 to Cannon Stocks and Securities Convertible Into Cannon Stocks (%) — PS10/PK10 (same as IA1)

PS10/PS10 are defined same as IA1

Initial/Average Percentage of Dow Jones Composite Average Stocks to Cannon Stocks and Securities Convertible Into Cannon Stock (%) —

PS11/PR11 (same as IA2)

PS11/PR11 are defined same as IA2

Initial/Average Number of Security Investments (Excluding Cash and Equivalents) — PS12/PR12

/Number of Separate Senior Securities Issues, (e.g., \ / Bonds, Preferred Stocks, etc.), Common Stocks of Dif4 1 ferent Corporations, and Other Securities or Options j

PS12/PR12 =*Convertible into the Above Securities). Initial/Average Dollar Amount Invested Per Security Investment ($) — PS13/PR13

/Portfolio Net Asset Valued- jCash, Marketable! PS13/PR13 =1 ] 'Securities

Number of Security Investments at Period-End

Average Annual Turnover (%) — PB14 (same as PE13) [MINIMUM of: 1) Portfolio Security Purchases; or 2) Sales\

PR14 =1 Excluding Short-Term Marketable Security Transactions _ 1 xi007o [Average of Period-Beginning and Period-Ending Portfolio j 'Net Asset Value

NOTE: PR14 is the same definition used currently by the Investment Company Institute in its annual Mutual Fund Fact Book.

218

PORTFOLIO EVALUATION

NOTE: F£1 through PE14 are the intertemporal standard deviations around the mean values PR1 through PK14, respectively. PE15 through EE18 are the intertemporal standard deviations around the mean values CP1 through CP4, respectively. Each was cal-culated according to the following formula with the time inter-vals as noted below.

Intertemporal Standard Deviation for each portfolio characteristic is calculated from the following formula:

Intertemporal T.Portfolio Average Standard = [Measure Portfolio Deviation |zlCharacteristic - Characteristic

for period "t" for entire period "T" t - 1

Where: the period "t" is as follows for the listed portfolio characteristics

"t" is quarterly "t" is semi-annually "t" is annually

PR1 PK14 FR6 PR2 CP1 PR7 PR3 CF2 PR8 PR4 CP3 PR9 PR5 CP4 PR10 PR12 PR11 PFJL3

Average Management Fees and Expanses per 6 months ($) — PE19

PE19 = Management Expenses in Dollars (ME($) includes Management Advisory fees as well as other expenses charged to the specific dual fund.

Average Excess Current Return (%) — PE20 (same as CP4)

PE20 defined same as CP4

Average Annual Turnover (%>) — PE21 (same as PR14)

PE21 defined same as PR14

Average Management Expenses (%) -- PE22 Management Expenses ($)

FE22 = Average of period beginning and period ending NAV x 100%

NOTE: PE22 is the same definition as used by Arthur Wiesenberger & Co. in its annual Investment Companies for annual management expenses.

219

(JEER DEFTNITICES

Dual Fund "Unit" = Number of preferred shares matched against nuicer corresponding capital shares

NOTE: (1) All Html funds except PUTNC have 1 preferred share for each capital (cannon) share; PUTNC has 1 preferred share for every 2 capital (cccroon) shares. (2) LFB and SDV had limited repurchases of both preferred and capital shares in 1972 and 1973; in each case, total re-purchases were less than 0.6% of initial number of outstandi shares.

Net Asset Per "Unit"

.ding

FtAV/Unit = Portfolio net asset value Number of dual fond "units" outstanding

Gross Incase Per "Unit"

Gl/Urdc = Total gross portfolio revenue

Number of dual fund units outstanding

Capital Gain Distribution Per "Unit"

CG/Uhit = Total capital gains distributed NumDer or dual fund units outstanding

NOTE: All tins-oriented percentages, e.g., I?l, IP2, CP1, CP2, CP3, PR14, etc., have been annualized for 1967 according to the following formula:

Computed \ / Annualized 1967 Value 1967 jxi 365 cays i

Value I \S of days dual niid/ was m operation in 1967

MEASURES OF PORTFOLIO RETURN

Mean of Annualized Arithmetic Returns (generally referred to as "Arithmetic Mean")

T , Arithmetic Mean = £ (Arithmetic Mean for Quarter "t"'

t = 1

220

Where: Arithmetic Return for Quarter "t" -

(Quarter-Ending Dual Fund Unit Value

- (Quarter-Beginning Dual Fund Unit Value)

+ (Gross Income Per Dual Fund Unit Value)

_+ (Capital Gains Taxes Paid Per Dual Fund Unit)*.

x 4 x 100%

(Quarter-Beginning Dual Fund Unit Value)

Capital Gains Taxes were paid by each Dual Fund -where applicable to maintain the appropriate tax status with IRS; all capital gains taxes were "flowed" through to capital share owners in the form of tax credits or adjustments to capital share cost bases.

GEOMETRIC RETURN

Geaaetric Return (GM) =

(Period-Ending Dual Fund Unit Value) (Period-

Beginning Dual Fund Unit Value) + (Gross Inccme

received per Dual Fund Unit Value) + (Capital

_ Gains Taxes paid per Dual Fund Unit) -

1/T

-1

Period-Beginning Dual Fund Unit Value

x 4 x 1007,

NOTE: All periods were quarters

ARinMETIC RISK PREMIUM TO VARIABILITY (Risk Premium to Variability)

Risk Premium to Variability -.Arithmetic Mean - Risk Free Interestx [ Rate t ] 1 Intertemporal Standard Deviation J ^ around Arithmetic Mean /

221

Where: 1. Risk Free Interest Rate = 5% which is the appropriate

average yield cm 90-day Treasury bills for March, 1967

to Decanber, 1973.

2. Interemporal Standard Deviation (ISD) around Arithmetic

Mean equals:

I - " I ) 2 li>|

»

Where t = nuiiber of periods for each dual fund annualized

ARf- - annualized arithmetic return during period, "t"

ARfj ~ mean of annualized arithmetic returns

t = sequential quarter, 1... .T

APPENDIX B

VARIABLE VALUES USED FOR REGRESSION ANALYSIS

523

CO

KQ I N

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O O O O O O I N I T I I N T N C N M C S I N

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APPENDIX G

SAMPLE OF DUAL-FUND PORTFOLIO MANAGEMENT QUESTIONNAIRE

227

DUAL"FUND PORTFOLIO MANAGEMENT QUESTIONNAIRE

Tliis questionnaire was designed for use by both past and present Dual Fund Portfolio Managers; therefore, please provide answers that best describe the situation as it was (is) when you were (are) the portfolio manager. Please feel free to use the back of any page to expand on any answer.

NAME OF DUAL FUND

APPROXIMATE TIME PERIOD WITH DUAL FUND AS PORTFOLIO MANAGER

1.

2.

3.

What factors led to selecting the initial proposed size of this portfolio as

indicated in the initial prospectus?

What factors led to selecting the specific guaranteed, cummulative preferred

dividend on the preferred stock: : —

What factors led to selecting an escalating preferred dividend and/or escalating preferred dividend redemption price, if any? ,

a.

b.

Was there a serious concern about the successful initial sale of all or

most of either class of stock? Yes No_ If "Yes", which class of stock? Preferred Shares Capital Shares Both Explain briefly ;——

What was'ThT initial portfolio strategy/policy/philosophy? (If this is specified in. any publicly available information, simply reference the source).

6.

7.

Do you believe that"the" above portfolio strategy/policy/philosophy repre-sented the focal point of subsequent portfolio decision making? No Yes Generally

No Was there an explicit initial portfolio planning horizon? If "Yes", how long was it?_

Yes

How long were subsequent, formal portfolio planning periods, if any?

How long was the time period from the initial purchase of securities after the fund began until the fund was essentially fully invested?

market days. On what percentage does your dual fund depend for its research:

^ Internal to fund or fund group. % External to fund or fund group.

228

10. Does your internal research: specialize in particular industries, companies cover essentially all industries, companies

11. Does your internal research direct efforts toward developing BUY, HOLD, SELL" lists? Yes No

12. How would you characterize the emphasis of your research? % "Fundamental" % "Technical"

13. Does your internal research capabilities include an economist specializing in macro-economic forecasting? No Yes

14. Does your internal and/or external research include explicit interest rate

forecasts for your planning period? Yes No——___ 15. Does your internal research provide you with explicit statements of.

Present market condition Yes No Expected future market conditions Yes_ No

16. Do you believe that your internal and/or external research provides you with sufficient and timely SELL recommendations? Yes _ No

17. Is the primary research that leads to BUY/SELL-type of recommendations normally performed, by the portfolio manager(s)? No Yes __

18. Describe briefly the portfolio decision—making organization including size, composition, role of the portfolio manager, and other related matters.

19. Is portfolio turnover subject to general guidelines? Yes No If so, what amount of turnover is permissable? %

20 1 . 1 S U J W L i d L. C U J J . U U . J U U W i . UU.JL. u w V w a, -u ^ f »• — ~ — — — * —

Are you personally satisfied with the diversification (industries, number

of securities, etc.) of your portfolio? No Yes What changes would you preferred to have been made

21. Is the percentage of the portfolio invested in fixed—income securities versus non—fixed—income securities sub3ect to a general guideline?

Yes No If so, what was the suggested % of fixed-income securities?

22. Approximately what percentage of the BUY/SELL recommendations presented to" the portfolio manager/committee were actually executed?. %

23. On average, what percentage of BUY/SELL executions do you believe were based on thorough, reliable, and timely information? _%

24. Who proposed initial major mix proportions (e.g., % fixed-income versus non-fixed-income securities, relative weights of industries)?

research department ~ — — — portfolio manager(s)

board of directors _other (specify)_

25. Were any substantial changes made in the major mix of fixed-income versus non-fixed-income securities in the portrolio? No Yes _ If "Yes", why were these changes made and who initiated the proposed change

229 26. Would you characterize the majority of the changes in your portfolio as:

Anticipation of change Reaction to change Both 27. Do you use a systematic and formal system of comparing BUY/SELL recommen-

dations with actual results? Yes No 28. Do you normally analyze past purchases or sales to determine the effective-

ness of portfolio changes? No Yes 29. Do you normally calculate the volatility of your portfolio compared to

market (i.e., the "0")? Yes No If "Yes," do you believe that this measure appreciably assists you in portfolio decision making? Yes No

-30. How frequently do you receive an internal report on the performance of the portfolio as well as comparable standards (e.g., market indices, etc.)_

31. Which market indices do you follow closely as a standard against which to compare your performance for internal purposes? a. MARKET PRICES

DJ Industrial Average NYSE Composite DJ Composite AMEX Market Value Index ~DJ Utilities NASDAQ OTC Composite ~DJ Transportation Value Line 1400 S & P 425 Industrial Other Dual Funds S & P 500 Composite _0ther (Specify)_

b. MARKET YIELDS DJIA Dividend Yield 13 week T-bill rate S & P 42.5 Yield Long-term, U.S. Treasury bond S & P 500 Yield Yield-to-maturity Other (Specify) Barron's 10 Highest grade bonds

Yield a. Did any significant change occur in the portfolio strategy/policy/phi-

losophy from the portfolio strategy/policy/philosophy existing when your dual fund was begun? Yes No

b. If "Yes," briefly explain why the change was made and what the revised strategy/policy/philosophy is

33. Was any effort made to investigate the preferences of the individual share-holders of each class relative to risk/return, time sequencing of returns, or other related matters? No Yes If "Yes," describe briefly the survey,- conclusions, and resultant changes in portfolio management_

34. Does your organization have a plan for staffing the portfolio manager position from now until the termination of the fund? Yes No_

35. Does your organization have formal, written policies concerning (circle best response):

Primary Nature and Function of Cash Management Research Making Investment Portfolio strategy/policy/ Recommendations philosophy Other (Specify) Jlrading

Please attach copies of any written policies concerning these or related portfolio management matters.

230 36. How many full-time employees work for your dual fund? (fractional values

are acceptable, if applicable) Portfolio Manager(s)

i Research Analysts Clerical/Secretarial Trader/Other (Specify)_

TOTAL

37. Does your organization allow you to manage more than one fund at a time? No Yes Does your organization limit you to managing a maximum amount of funds? No Yes If "Yes", how much:$ million.

38. Are management expenses monitored and justified? Yes_ No_ 39. Describe your view of the investment advisory fee: (exclusive of reimbursed

expenses) Inadequate for quality of services and performance rendered _Adequate for quality of services and performance rendered _More than adequate for quality of services and performance rendered

40. Describe briefly what changes you would make in the advisory fee compensation system: i__

41. How would you rank the "quality" and/or "professionalism" of your dual fund organization and its members compared to other competitive fund organizations and personnel (not just other dual funds)? -

Far below Below Above Average Average Average Average Oustanding

42. If you had an opportunity to change anything about your dual fund, what would you have done differently and why? ________

43. Feel free to comment extensively on your views of portfolio management, the dual fund industry, etc., on the back of these pages. Thank you very much for your assistance.

APPENDIX D

"PORTEVAL" COMPUTER PROGRAM LISTING AND SAMPLE OUTPUT

232

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APPENDIX E

SUMMARY OF DUAL-FUND PORTFOLIO MANAGEMENT QUESTIONNAIRES

248

RESPONDENT'S APPROXIMATE TIME PERIOD WITH DUAL FUND:

ADV: GEM: HEM: ICS: LFB: PUINC: SCD(I): SO) (II)

3 years

1% years

2 years 4% years 6 years 7 years

What factors led to selecting the initial proposed size of this port-folio as indicated in the initial prospectus?

ADV GEM HEM ICS

LFB:

FUTNC: SCD(I): SCD(II)

Ability to sell.

Don't know-was not here at that time. Money raised through an underwriting with $30,000,000 as the target which was reached. This was deemed to be an economically viable size. Underwriters estimate of what could be sold and what was a manageable size. Market danand. Estimate market demand. Investor interest.

What factors led to selecting the specific guaranteed, cumulative pre-ferred dividend on the preferred stock?

ADV GEM HEM ICS

LFB:

PIUNC:

SCD(I)

SCD(II)

Market factor.

Don't know. Many factors—we wanted a minimum dividend of 50$ to give a return on purchase price which would be considered attra-tive in the then money market. Estimated yield on a 1967 Portfolio of quality companies selected fran the S & P 500. Set low so as to facilitate capital gains in early years, allowing escalation of dividend later. Projections of income growth and expenses plus desire to set" rate which we thought was within realistically achiev-able bounds. First of all, you should recognize that "guaranteed" is not a phrase correctly applicable to all of the dual-purpose funds. Our dividend is cumulative, but not guaranteed, and I think you mil find this to be the case in other instances.

We selected our rate of 64c, which is 7% of the par value of 9.15 on the following basis:

249

SCD(II) Contd.

(a) At that time, long-term Treasury bonds were selling to yield 4-1/4% and long corporated 4-3/47o to 5%.

(b) We believed that the income investor should get a cumu-lative rate -which represented a significant premium over incane alternatives since he was giving up the prospect of capital growth.

(c) While we stated in the prospectus that we did not ex-pect to, earn the dividend in the early years, our stu-dies and our belief was that there would be no diffi-culty earning it on a cumulative basis over the 15-year life of the fund.

What factors led to selecting an escalating preferred dividend and/or escalating preferred dividend redemption price, if any?

ADV GEM HEM ICS LFB: FUTNC:

SCD(I): SCD(II)

Marketability.

Not applicable.

Not applicable. Facilitate marketing of the fund by offering a unique "extra".

Not applicable.

Was there a serious concern about the successful initial sale of all or most of either class of stock? Yes No If "Yes", -which class of stock? Preferred Shares Capital Shares Both

Preferred Shares.

know.

ADV: Yes: ®M: HEM: DanK

ICS: More LFB; No. PUTNC: Yes: SCD(I): No. SCD(II): No.

Both.

the source). simply

ADV GEM HEM ?„ 3, 4, 5 of original offering Prospectus.

[following is referenced section of Prospectus] Hie investment objectives of the Fund will be to seek long term growth of both income and capital, consistent with providing current incase sufficient: to meet the higher of

250

HEM Contd. (5)

ICS: LFB:

FUTNC:

SC3)(I) :

6.

the Portfolio Yield Objectives or the minimm annual $.625 dividend requirement of the Tncctne Shares. Cannon stocks and securities convertible into or exchangeable for ccranon stocks will generally constitute the Fund's principal port-folio investments, although the Fund may also invest in bonds, debentures and other debt securities. The Fund has no fixed policy as to the proportion of its assets that may be invested in each type of security [reference material also includes definition of rortxo .o Yield Objective" and "other Investment Policies"]

Offering Prospectus: Generally that investment is a repre-sentative list of quality growth utilities, industrial coram stocks, and convertible bonds "would result in in-creasing inc.cme. and capital over life of the Fund of 15 years. "Middle-of-the-road", as described in George Putnam Fund annual report for 1973. [referenced materials on following page] See Prospectus, page 3._ [referenced materials follows] Investment Policy: The cut up any will invest principally in cannon stocks (and to a less extent convertible securities). Emphasis will be placed on the selection of securities o£ companies which management believes have above-average prospects for growth of earnings. This reflects manage-ment's experience and belief that earnings are the primary source of dividends and that the long-term trend of earnings is one of the best guides to probable investment results, whether measured by dividends or capital appreciation. Therefore, companies with growing earnings are more lilcely to afford over the long-term greater protection to dividends and investment values as well as greater total cumulative dividend payments and enhancement of capital value. Thus, the company will not seek maximum current incase nor specu-lative short-term capital profits but concentrate, in the interest of both classes of shareholders, _on a portfolio of investments which it believes will afford above-average earnings growth and total dividend payments over the long-term.

SCD(II): Prospectus [respondent referenced same materials as SCD(I)]

Do you believe that the above portfolio strategy/policy/philosophy represented the focal point of subsequent portfolio decision making? No* Yes Generally

ADV GEM HEM ICS LFB

Yes.

Don't know. Yes. Generally.

251

(continuation of PUTNC answer to #5)

The George Putnam Fund Profile

The George Putnam Fund of Boston is a "balanced" fund designed to provide a •well-rounded, middle-of-the-road investment program for the prudent in-vestor—a program in which he can feel justified in placing a substantial portion of his investment funds.

Since its founding in 1937, the consistent aim of the Fund has been three-fold—

- Long-Term Growth of Principal

- Reasonable Current Income

- Preservation of the Investor's Principal

In accordance with this aim, the Fund invests in a carefully diversified portfolio of selected cannon stocks, preferred stocks, and bonds, in-cluding convertible securities.

A balanced investnsnt program such as provided by the Fund cannot eliminate risk or assure the achievement of its objectives diligently and continu-ously.

Portfolio Strategy

As you know, your' Fund takes a balanced investrjsnt approach, with cccmon stocks for growth and bonds for current income and stability. To those who do not fully understand it, this middle-of-the road approach may seem a "ho-hum" way of investing. On the contrary: successful balanced in-vesting requires high selectivity in individual issues and a great degree of flexibility.

232

6 Contd

HJENC; In 1968, a mare aggressive approach was adopted, then in 1971 we reverted to original approach,

SCD(I): Yes. SCD(II): Yes.

Was there an explicit initial portfolio planning horizon? Yes_No__ If "yes", how long was it? — , — , ... How long were subsequent, formal portfolio plaiiLiirig periods, it any.

9.

ADV: Yes; 1 yr.; 1 yr. GEM: HEM: ICS: No. ^ ^ LFB: Yes; 6 months to become fully invested; not applicable. PUINC: Yes; 2 - 3 years; in 1968-1970, 6-12 months. SCD(I): No. SCD(II): Yes; long-term.

How long was the time period frctn the initial purchase or securities after the fund began until the fund was essentially fully invested?

market days.

200. ADV: GEM: HEM: ICS: LFB: PUTNC: SCD(I): SCD(II): 120.

30. 150. 100 + . 60.

On what percentage does your dual fund depend for its research: % Internal to fund or fund group. External to fund or fund group.

•k

ADV GEM HEM ICS LFB PUTNC SCD(I) :

507., 501. "great preponderance or research... is generated internally . 607., 40%. 60%, 407a. 67%, 33%. 80%, 20%. 100%, 0%.

10.

SCD(II): 1007. Internal to fund or fund group.

Does your internal research

panies OR specialize in particular industries; con-

cover essentially all industries, companies,

ADV: GSM:

Cover essentially all industries.

2 5 3

LO Contd

11.

12.

Specialize in particular... Cover essentially all industries, Specialize in particular... Specialize in particular. Cover essentially all industries, Specialize in particular...

HEM: ICS: LFB: FU1NC: SCD(I): SCD(II):

Does your internal research direct efforts toward developing BUY, .HOLD, SELL" lists? Yes No

1 3 .

ADV: Yes. GEM: HEM: Yes. ICS: Yes. LFB: No. PUTNC: Yes. SCD(I): Yes. SCD(II): Yes.

How would you characterize the anphasis of your research? % ''Fundamental" % "Technical"

it ADV: GEM: HEM: ICS: LFB: PUTNC: SCO(I): SCD(Il)

1 0 0 7 o Fund. "Fundamental bias" • 100% Fund. 90%, Fund, 10% Technical. 90% Fund, 10% Technical. 9G% Fund, 10% Technical. 95% Fund, 5% Technical. 99% Fund, 1% Technical.

Does your internal research capabilities include an economist speciali-zing in macro-econanic forecasting? No Yes

1 4 .

ADV: No. GEM: HEM: No. ICS: Yes. LFB: No. PUTNC: Yes. SCD(I): Yes. SCD(II): Yes.

rate forecasts for your planning period? Yes No

ADV: Yes. GEM: HEM: Yes. ICS: Yes. LFB: Yes. FUTNC: Yes. SCD(I) : Yes. SCD(II): Yes.

15.

16.

17.

254 _ Does your internal research provide you with: explicit statements of:

Present market condition Yes No Expected future market conditions Yes No

ADV: GEM: HEM: ICS: LFB: FUTNC: SCD(I): SCD(II):

Yes, yes.

No, no. Yes, yes. No, no. Yes, yes. Yes, no. Yes, yes.

Bo you believe that your internal and/or external research provides you with sufficient and timely SELL recanaendations? Yes No

ADV: No. GEM: HEM: Yes. ICS: Never sufficient. LFB: Yes. HJTNC: Yes. SCD(I): Yes. SCD(Il): Yes.

Is die primary research that leads to BUY/SELL-types of recomnenda-tions normally performed by the portfolio manager(s)? Yes No

ADV: GEM: HEM: ICS: UB: PUTNC: SCD(I): SCD(II)

Yes,

Yes. No. No. No. No. No.

IS. Describe briefly the portfolio decision-rnaking organisation including size, composition, role of the portfolio manager, etc. .

ADV GEM HEM

ICS:

LFB:

Total of 4 investment personnel, all of whom follow various stocks, and also manage sane portfolios within our organi-zation. Portfolio manager selects asset mix in the port-folio and chooses stocks frcm a broad group followed by the members of the organization. The chain of decision makeup runs frcm the Policy Ccomittee (Board Economic Trends) to Research Dept. (selection of securities frcm favored industries) Ratings-Security Selec-tion Ccomittee, and Fund Management Team with one particular manager assigned to each fund. 3 man Portfolio ConmLttee composed of President of Fund; Head of Research; Portfolio Manager in charge of all deci-sions. Investments recarmendations considered by 10 man

HEM Contd (18)

PUTNC:

SCD(I):

SCD(II):

255

investnent committee, including above 3. Ifejority vote and 2/3 of Portfolio Committee required to Buy/Sell, but Port-folio Committee can act in absence of Pull Carmission. Autonomous portfolio manager receives advice frcm 12 anal-ysts and an Investment Policy Cannittee. He is then sub-ject to periodic review and critique frcm Investment Policy Ccomittee. See enclosed table of organization. [respondent attached following 2 pages] Answering this question could take many words, but I shall be brief. Wa are a large organization with a research de-partment numbering over 100 persons and our total organiza-tion is approximately 600. We have AO equity analysts, 3 economists, 14 bond specialists, etc. _ The portfolio of deci-sion-making organization involves an investment policy caa-mittee, group research managers, and highly experienced analysts. All of these supply general guidelines and frunda-mental research to highly trained portfolio managers wio have authority to act within prescribed guidelines. It is important that the portfolio manager have sufficient leeway to* add value at his level—and that is the way we have structured ourselves.

19. Is portfolio turnover subject to general guidelines? If so, what amount of turnover is permissible?

Yes No

20.

ADV: Yes, 100%. GEM: HEM: No. ICS: Yes, 507o-7O7o varies frcm year to year. LFB: No. PUTNC: No. SCD(I): No. SCD(II) : No.

Are you personally satisfied with the diversification (industries, number of securities, etc.) of your portfolio? __No Yes What changes would you prefer to have mace? .

ADV: Yes. GEM: - . . HEM: At the present time we have a small number of securities

as much of the portfolio is in commercial paper. ICS: Never wholly satisfied. LFB: Yes. PU3NC: Yes. SCD (I): Yes. SCD(II): Yes.

256

(continuation of SCD(I) answer to #18)

SCUPPER, STEVENS & CLAKK'

We are an independent investment counsel firm and have no connection with a broker, insurance company or bank. Organized in 1919 for the purpose of providing unbiased and professionally informed investment advice on a contin-uing basis to individual and institutional clients, we have grown through the years to one of the largest such firms in terms of assets managea and personnel. Fees for investment management are our only source of income, and every effort is directed solely towards providing our clients with the close personal investment supervision and service they expect from us. Our objective nas always been to pursue an identity of interest with our clients.

The total employees of the firm number 585, and our offices are located in 12 cities„ We believe that our staff is unusually'well-balanced in abilities, experience, age and professional and academic qualifications; the^educational background of our staff includes the following degrees: 2 Ph.D., 82 MBA, 13 KA, and 17 LLB/JD. Our services and competence embrace expertise m various specialized areas such as taxation, Government regulation of the securities industry, nnancia planning-, and retirement fund operation and structure.

Scudder, Stevens & Clark has supervised portfolios with a wide range of in-vestment objectives in contrast to many firms which concentrate their efforts towards a specific investment objective to the exclusion of others. We^have thus accumulated skills and experience in managing both individual and institu-tional portfolios whose characteristics require the assumption of varying degrees of risk and long-term goals*

Unlike many others in the investment field we. have long followed the policy of avoiding close identification with other businesses, such as serving on boards or having outside directors of our firm, with the objective of assuring as mucn freedom of choice as possible in our role as advisor.

( c o n t i n u a t i o n o f S C D ( I ) a n s w e r t o # 1 8 )

257

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21.

2 5 8

Is the percentage of the portfolio invested in fixed-income securities versus non-fixed-income securities subject to a general guideline?

Yes No If so, what was the suggested % of fixed-inccme securities?

23.

ADV: GEM: HEM: ICS: LFB: HJTNC: SCD(I) : SCD(II) :

Yes, 307,.

No-Yes, varying according to Policy Committee guidelines. No. No. No.

22. Approximately what percentage of the BUY/SELL reccranendations pre-sented to the portfolio manager/ cccnnittee were actually executed?_

A D V : 1 0 0 7 o .

GEM: HEM: ICS: LFB: FUINC: SCD(I): SCD(II):

On average, what percentage of SO f/SELL executions do you beiieve were based on thorough, reliable, and timely information?_

65%. 207.. 100%.

ADV: 60%. GEM: HEM: ICS: LFB: 90%. FUTNC: 100% SCD(I): 10C% SCD(II): All.

24. Twho proposed initial major nix proportions (i.e., % fixed-inccce versus non-fixed- income securities, relative weights of industries, etc.)?

research department portfolio manager(s) board of directors "other (specify)

ADV: Board of directors. GEM: HEM: Portfolio manager. ICS: Research department, LFB: Research department,

underwriters. RJIMC: Research department, SCD(I): Research department, SCD(II):

259

25. fere any substantial changes made in the major max of fixed-ixlccce versus non-fixed-income securities in the portfolio, No—_ Yes If "Yes", why were these changes made and who initiated the proposed change?

ADV GEM HEM

ICS: LFB: FUTNC:

SCD(I)

No.

Yes total assets declined to the point where the incase generated from stocks was inadequate to cover the minimum required dividend., Therefore, bonds snd cxxnneruxsl psper were purchased. Also, stocks were reduced in view of the poor market environment during the past 18 months. Change initiated by portfolio manager.

Yes, portfolio manager recommends changes periodically for control of volatility and for inccme reasons. Yes change made to anticipate deterioration in equity prices. Change initiated by portfolio manager in response to research findings.

SCD(II): No.

26. Would you characterize the majority of the changes in your portfolio Anticipation of change Reaction to change Both. as:

ADV: GEM: HEM: ICS: UB: PUTNC: SCD(I): SCD(II)

Both.

Anticipation. Both. Both. Both Anticipation Both

28.

Do you use a systesatic and formal system of comparing BUY/SELL re-carmendations with actual results? Yes No

ADV: Yes. GEM: HEM: No. ICS: Yes. LFB: Yes. R7TNC: Yes. SCD (I) : No. _ , , . ,, SCD(II): Not applicable to just the dual fund—out to entire bcuader

effort.

Do you normally analyze purchases or sales to determine the effective-ness of portfolio changes? No Yes

ADV: GEM: HEM:

Yes.

Yes.

28 Contd. 260

29.

ICS; LFB: PUTNC: SCD(I): SOD (II) :

Yes, Yes. Yes, Yes. Yes.

Do you normally calculate the volatility of your portfolio ccopared to market (i.e., the "$")? Yes No If "Yes," do you believe that this measure appreciably assists you in portfolio decision-making? Yes No

ADV: GEM: HEM: ICS: LFB: FUINC: SCD(I): SCD(II)

No.

No. No. Yes, yes. Yes, yes. No. Sometimes; no.

30. How frequently do you receive an internal report on the performance 1 J J 3 _ / ^ ^ J -*** JtJt ^

etc.).

ADV: OEM: HEM: Monthly. ICS: Monthly. LFB: Weekly. PUTNC: Weekly. SCD(I): Monthly. SCD(II): Monthly.

31.

(a)

Which market indices do you follow to compare your performance for in! MARKET PRICES

DJ Industrial Average DJ Casposite DJ Utilities

closely as a standard against which :ernal purposes?

_NYSE Composite AMEX Market Value Index

~DJ Transportation S & P 425 Industrial

ADV: GEM: HEM: ICS: LFB: PUTNC: SCD(I)

~S & P 500 Composite

"NASDAQ OTC Composite Value Line 1400 _0ther Dual Funds "Other (Specify)

DJ Industrial, S & P 425, Other Dual Funds. DJ Industrial, S & P 500, NYSE, Other Dual Funds. DJ Industrial, S & P 500, Other Dual Funds. DJ Industrial, NYSE, Other Dual Funds. [Respondent enclosed following list] Market Indices

Stocks

261

SCD(I) Contd, (31)

D-J Industrial Average D-J Stock Average D-J Utility Index S&P 425 Stock Index S&P500 Stock Index N.Y.S.E. Irid. Index N.Y.S.E. Cctnp. Index A.S.E. Index Toronto Industrial Index Europe Index Europe, Aust., and Far East Index Japan Index Keefe Bank Stock Index

Fixed Income Securities Pfd. Stock Average GG-LD 15 Year AA Moderate Dis. Utility Scudder Corporate Bond Index Moody's Municipal Bond Average "Bend Buyer" Municipal Solomon Bros. High-Grade Corp. Index

Mutual Fund Averages All Funds Growth Funds Growth & Income Funds Balanced Funds Income Funds

Market Indices Dow Jones Industrials Standard & Poor's 500 Toronto Industrials

Fixed Incase Municipal Bond Index 25 Year AA Dis. Utility Bond Index "Bond Buyer" Municipal Salomon Bros. High-Grade Corp. Bond Index

SCD(II): DJ Industrial Average, DJ Composite, DJ Utilities, DJ Transportation S&P 425 Industries, S&P500 Composite, NYSE Composite, AMEX Market Value Index, NASDAQ CTC Composite, Value line 1400, Other Dual Funds

31. (b) M4BKEI YIELDS

DJIA Dividend Yield 13 week T-Bill rate

ADV.-GEM:

"S&P 425 Yield Long-tern, U.S. Treasury bond yield-_Barrcr yield

"S&P 500 Yield yield-to-maturity "Other (Specify) Barron's 10 highest grade bonds

262

31(b) Ccntd,

HEM:

ICS: LFB: RJINC:

SCD(I): SCD(II):

32. Did any change occur in the portfolio stxategy/policy/philosophy? Yes No If rfYes,T7~5riefly explain why the change -was made and what the revised strategy/policy/philosophy is ; . *

EJIA Dividend, S&P 425 Yield, 13 week T-bill, Long-term U.S.

S & P 500 Yield, 13 week T-bill rate, Barron's 10 DJIA Dividend, S&P 425 Yield, S&P 500 Yield, 13 week T-bill rate, long-term U.S., Barron's 10.

34.

mi GEM HEM

ICS:

LFB: FUTNC:

SCD(I):

SCD(II)

No.

Yes, see answer to question 25. Due to the depressed level total assets in the fund, emphasis must be placed on meeting Hie rm'm'mim dividend requirement. This is not a problem year due to high yields on cannercial papers. Yes, many changes over 7 years relative to the evaluation of economic and market trends.

Yes, as explained in number 5, we made the mistake of cctn-bining aggressive, volatile securities with leverage in 1963-1970, switching back to investment-grade issues sub-sequently . Underlying policy or philosophy is unchanged, but strategy is constantly changing as market conditions, economic out-look, etc. change. No.

33. Was any effort made to investigate the preferences of the individual shareholders of each class relative to risk/return, etc. No Yes If "Yes", describe briefly the survey, conclusions, and resultant changes in portfolio management.

ADV: GEM: HEM: ICS: LFB: HJINC: SCD(I): SCD(II) :

No.

No. No. No. No. No. No.

Does your organization have a plan for staffing_the portfolio manager position from now until the termination of the fund? es No

ADV: No. GEM: HEM: No. ICS: \ss •

263

34 Contd,

35.

37.

LFB: PUINC: SO) (I) : SCD (II) :

Yes. Yes. Yes. Yes.

Does your organization have formal, written, policies concerning. Primary Nature and. Function of Cash. Management Research Making Investment Eeccm-Portfolio Strategy/Policy/ Philosophy Trading

mendations Other (Specify),

ADV GEM HEM ICS LFB

PUINC:

SCD(I):

SCD(II)

No, yes, no, yes, yes No formal policiss Portfolio Strategy, Trading, Cash Management, Making divest-ment. [Respondent attached descriptive materials on Vance Sanders & Cccpany. ] See enclosed brochure for Putnam Advisory Company, an affil-iate of Putnam Management Company [Referenced material is on following page] Primary Nature, Portfolio Strategy, Trading, Cash Manage-ment, Making Investment Primary Nature, Portfolio Strategy, Trading, Cash Manage-ment, Making Investment, Policies are confidential.

36. How many full-time enployees work for your dual Fund? values are acceptable, if applicable)?

Portfolio Managers (s) Research Analysts

(Fractional

_Clerical/Secretarial "Trader/Other (Specify)_ "Total

ADV: GEM:* HEM: ICS: LFB: PUINC:

SCD(I):

SCD(II)

3, 3, 2, 1, 9 total 1, 3 2, 2, - 4 total 5(1 lead man), 12, 2, 1, 20 total 1, 9, 3, 1, 14 total 1, - not applicable, ours is a large organization managing $3 billion and employing 300 people. The fund has no direct employees; no employee of the advisor works full time on the fund, but dozens contribute to its management directly or indirectly. See response to question 13.

Does your organization allow you to manage more than one fund at a time? No Yes Does your organization limit you to managing a maximum amount of funds? No Yes , If "Yes"', how much $ million.

264

(continuation of PUTNC answer to #35)

THE INVESTMENT PHILOSOPHY; PBOVEN

The following are sane of the considerations that make up our investment philosophy. They provide the key: to seek superior investment perfor-mance for your portfolio through investing in securities of quality, imagi-natively selected, and continously supervised.

Emphasis on Quality. By quality, we do not mean the "Blue Chip" reputa-tion of a company,"'Dut rather the quality and visibility of its earnings growth. We look for those companies whose managements have been able to dsnonstrate above-average growth in past earnings and, more importantly, appear able to continue that growth of earnings in the future.

Concentration. Once we make up cur mind about a stock, we want to commit enough money to it to be well rewarded for our efforts. The first 25 stocks we select for a portfolio are, by definition, better than the first 50 we might choose. In other words, we believe in maximum concentration of holdings consistent with statistically adequate diversification.

Imaginative Selection.. .And Supervision. Having narrowed selections to those companies we believe will lead in earnings and investor interest over a period of time, we are very attentive to what is going on - in the com-pany, the industry, in government, with the consumer, in research - to sense any change in trend. Only by being alert and open-minded can we identify those companies moving ahead... eliminate securities of those com-panies which show hesitation.

Long-Term View. We believe major gains are made over the long term, not by trying to outguess near-term market fluctuations, but by having funds in-vested early in those companies and industries that will be the major bene-ficiaries of basic change.

Responsiveness To Change. If, however, we foresee a significant decline in business activity aid profits, we do not hesitate to convert a portion of cannon stock holdings into cash equivalents, government issues, or other defensive-tyce securities.

* A.

Fixed-Income Securities. We believe that the fixed-income sector of a portfolio should be as imaginatively and carefully managed as the common stock portion. At Putnam, investment in fixed-income securities is not just a defensive act but is geared to produce results, both in terms of yield and of capital appreciation.

265

37 Caitd.

39.

ADV: GEM: HEM: ICS: LFB: PUINC: SO) (I):

Yes, no.

Yes, no. Yes, yes, 2 funds Yes, no. Yes, no. Yes, no.

- if not incompatible.

SCD(II): Yes.

38. Are management expenses monitored and justified? Yes_ No

Yes. ADV: GEM: HEM: ICS: LFB: PUTNC: SCD(I): SCD(II):

Describe your view of the investment advisory fee: (exclusive of re-imbursed expenses). . ^

Inadequate for quality of services and performance rendered ""A J r\-£ roc and nPTTnrrnsnCS j-STldGlTBdl

No. Yes. Yes. Yes. No.

inadequate J-UJL ucu-j-uy ui. o A. T i "Adequate for quality of services and performance rendered More than adequate for quality of services and performance "rendered

ADV: GEM: HEM: ICS: LFB: PUTNC: SCD(I): SCD(II):

Adequate.

Adequate. Adequate. Adequate. Adequate. Adequate. "Marginally1 adequate for quality.

40. Describe briefly ~what changes you would make in the advisory fee can-pensaticn system:

ADV: GEM: HEM: ICS: LFB: PUTNC: SCD(I): SCD(II) :

None.

None. None. None. Ncne. None.

41. How would you rank the "quality" and/or "professionalism" of your> rh i fund organization and its naribers compared to other competitive fund organizations and personnel (not just other dual funds)?

266

(continuation of SCD(II) answer to #41)

SCUDDER. STEVENS & CLARK

CHARTERED FINANCIAL ANALYSTS MEMBERSHIP As of January 1, 1974

Number of CFAs

Scudder, Stevens & Clark

Compared to Other Investment Counsel Firms

SCUDDER, STEVENS & CLARK 46

Loomis Sayles & Co. 33

David L. Babson & Co. 16

Lionel D. Edie ^ Co, 15

Alliance Capital Management Corp. 13

Stein, Roe & Farnham 11

Jennison Associates Capital Corp. 5

T. Rowe Price 5

Eaton & Howard, Inc. 3

Ihomdike, Doran, Paine & Lewis 3

Scudder, Stevens & Clark Compared to Major Banks

SCUDDER, STEVENS & CLARK 46

Chase Manhattan Bank 20

Continental Illinois NatT1 Bank & Trust 12

Morgan Guaranty Trust 12

National Bank of Detroit 12

First National Bank of Chicago 9

First National City Bank ~ New York 9

U. S. Trust Company - New York 9

Northern Trust Company 8

Old Colony Trust 8

Wells Fargo Bank 8

Cleveland Trust Company 7

Republic National Bank of Dallas 7

Bank of America N. T. & S. A. 6

Capital Research/Guardian Trust 5

Provident National Bank 4

SOURCE: Institute of Chartered Financial Analysts Eleventh Directory of Members - 1974

267

41 Ccntd.

Far below Below Above Average Average Average Average Outstanding

42.

43.

ADV: GEM: HEM: ICS: LFB: FUTNC: SCD(I): SO (II)

Below Average,

Above Average. Above Average.

Outstanding. Outstanding. Outstanding. [Respondent attached chart shown on following page that indicates that Scuader has more NY CPA's than any competitive money manage - organizations ]

If you had an opportunity to change anything about your dual fund, •what would you have done differently and why?

ADV GEM HEM ICS. LFB: Allowed income to Pfd. Shareholder to fluctuate more in

order to gain flexibility in seeking capital appreciation. Market environment has been different from that envisioned and experienced in 15 years prior to fund startup, and the "Slice'of American Industry" Portfolio expected to grow has fared poorer than expected.

PUTNC: We should have stuck to the middle-of-the-road philosophy of the George Putnam Fund, a balanced fund after which our fund was patterned.

SCD(I): SCD(II) Nothing

Feel free to comment extensively on your views of portfolio manage-ment, the dual fund industry, etc., on the back of these pages. Thank you very much for your assistance.

ADV: GEM: HEM: ICS: PUTNC: The worst risk in dual funds is "over-managing" or trying

"too hard". They are best approached on a near-actuarial basis, ignoring shorter-term market fluctuations which in the case of the capital shares can be harrowing and lead to "whipsarn" decision-making. Also, it is best to monitor the total portfolio, as measured by a "unit" of income and cap-ital shares since performance of the Capital Shares alone is distorted and magnified by an arbitrary and varying leve-rage factor.

268

43 Ccntd.

SCD(I): SCD(II) :

Asterisked responses cam from letter to author fran Wellington Manage-ment Ccrapany, dated March 24, 1972.

269

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Other Materials

American DualVest Fund, initial prospectus, quarterly, semi-annual, and annual reports from inception through iy/J.

Bogle, John C., personal letter to author, June 28, 1974.

Gemini Fund, initial prospectus, quarterly, semi-annual, and annual reports from inception through 1973.

Hemisphere Fund, initial prospectus, quarterly, semi-annual, and annual reports from inception through 1973.

278

Income and Capital Shares, initial prospectus, quarterly, semi-annual, and annual reports from inception through 1973.

Kumar, Parmesivar, "Multiple Criteria Portfolio Selection in Dual-Purpose Funds: A Goal Programming Approach," Unpub-lished Ph.D. Dissertation, State College, Pennsylvania, The Pennsylvania State University, 1975.

Leverage Fund of Boston, initial prospectus, quarterly, semi-annual, and annual reports from inception through 1973.

"Measuring the Investment Performance of Pension Funds for the Purpose of Inter-Fund Comparison," Park Ridge, Illinois, Bank Administration Institute, 1968.

1974 Mutual Fund Fact Book, Washington, D. C., Investment Com-pany Institute, ly74.

Historical Chart Book, Washington, D. C. , Board of Gover-nors , Federal Reserve System, 1975.

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279

VITA

BRIAN BELT was born on April 6, 1945, in East Cleveland,

Ohio. He received the Bachelor of Industrial Engineering

(B.I.E.) degree in August, 1968, and the Master of Science

(M.S.) degree in Industrial Engineering in March, 1969. Both

engineering degrees were conferred by The Ohio State University.

During his M.S. degree program, Mr. Belt held a graduate fellow-

ship from the United States Public Health Service in the Trans-

portation Accident Research Graduate Education Training (TARGET)

program. Mr. Belt holds the Master of Business Administration

(M.B.A.) granted by Texas Christian University in May, 1970.

During the M.B.A. program, Mr. Belt held a fellowship with the

Bureau of Business Research at T. C. U. From January, 1971,

through December, 1976, Mr. Belt was a candidate for the doc-

toral degree at North Texas State University, majoring in man-

agement with minors in finance and quantitative methods.

The industrial experience of Mr. Belt includes work in

Management Systems as well as engineering worlc in production

scheduling, quality control, as well as product planning and

designing.

Currently, Mr. Belt is an Assistant Professor of Management

and Finance in the College of Business Administration at Texas

A & I University at Corpus Christi. He is a member of the

Academy of Management, American Institute of Decision Sciences

(AIDS), Financial Management Association (FMA), and Society

for the Advancement of Management (SAM). Recent publications

280

include articles in the National AIDS Proceedings, the Journal

of Financial Education, as well as articles in both Southeast

and Southwest AIDS Proceedings.

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