This question is for a clarification between a Total Return portfolio approach and Portfolio Segmentation approach. On page 309, Solution 1 to Example 18 states that the foundation should focus on a “total expected return” approach. Then, on page 312, for insurance companies, it emphasizes the benefits of a Portfolio Segmentation approach. Both foundations and insurance companies use the Asset/Liability Management (ALM) approach as they have to account for the characteristics of their liabilities, but I don’t quite understand when to use the Total Return vs. Portfolio Segmentation approach. Help would be much appreciated!
joung38, The total return approach is the approach that is used to formulate a return objective. The total return approach, according to the curriculum, is the preferred way to formulate a return objective relative to other methods of formulating a return objective. For example, one inferior method of formulating a return objective is to acheive an income return of 2.3%. Another inferior method of formulaing a return objective is to achieve a capital appreciation (growth) rate of 1.5%. As such, when you are asked on the exam to formulate a return objective, it is probably best to formulate a return objective using the total return approach. For example, you would want to say that a return objective for such and such an individual (or insurance company) is to earn a real, after tax return of, say, 3.5 percent to fund whatever it is that individuals or insurance want to fund (e.g., retirement, coverage of liabilities, etc.) The segmentation approach is what is used (for example, by insurance companies) to manage a portfolios to meet liabilities. For example, suppose that an insurance company sells fixed and variable rate annuities. The insurance company decides to segment its portfolio into two sub-portfolios: one portfolio for the fixed rate annuities and one portfolio for the variable rate annuities. So an insurance company could, using a total return objective, formulate a total return objective of, say 7.5%, necessary to fund its fixed rate annuities, and a total return objective of 6.5% to fund its variable rate annuities. So a segmented portfolio can be used to support these two total return objectives for the insurance company. I think you may be confusing how to run a portfolio (i.e., segmenting) to meet a return objective with how to formulate a return objective (i.e., total return approach) itself. Hope this helps.