2. Questions 7, 8, and 9, including Guideline Answers (Study Session 9)
b) recommend and justify changes in asset allocations, based on stated objectives and
expected returns, expected volatility, and expected correlations of returns;
c) recommend and justify changes in asset allocations, incorporating all aspects of the
investment policy statement.
Guideline Answer:
Recommend for
Yeo the most
appropriate
allocation range
Justify each of your responses with one reason based on
Asset Class
for each of the
Yeo’s specific circumstances
asset classes in
Exhibit 8-2
(circle one)
Yeo’s need for money market assets is minimal as the only
liquidity need mentioned is her desire for a cash reserve of six
0% to 10%
months of living expenses. In addition, the lowest allocation to
11% to 20%
money market is justified as its return will drag down total
Money Market
(Cash)
portfolio return.
21% to 30%
NOTE: The MYR2 million donation is 10 years from now and
is not a current liquidity requirement.
Yeo’s overall risk tolerance has only increased somewhat, and it
remains below average. As such, the highest allocation to bonds
31% to 40%
is most suitable.
NOTE: Bonds have a lower standard deviation than equities.
41% to 50%
Domestic Bonds
This will provide Yeo with lower overall volatility. While
51% to 60%
expected bond return is lower than equities, it is higher than
money market. As such, bond return should contribute more to
the 7% after-tax return objective than money market.
The lowest allocation to this asset class is recommended. After-
tax expected return is lower than domestic equity growth while
the risk (standard deviation) is virtually identical.
Domestic
NOTE: The after-tax expected return from domestic equity
Equity –
Income
income is 11.4% [7.5% × (100%-28%) + 6.0%], which is 1.1%
lower than the after-tax expected return of 12.5% from domestic
equity growth. Because the standard deviation of these two
classes is similar, domestic equity growth is preferable.
The maximum allocation to domestic equity growth is
warranted. This is one of two asset classes which exceed the 7%
required rate of return. The after-tax return for this asset class is
higher than that for domestic equity income, but the standard
Growth
deviation is almost the same. As a result, domestic equity
growth has the superior risk-adjusted return.
Sample allocation in correct ranges:
After-tax expected annual returns:
Money Market: 2.5% × (1 – 0.28) = 1.80%
Domestic Bond: 5.2% × (1 – 0.28) = 3.74%
Domestic Equity Income: [7.5% × (1 – 0.28)] + 6.0% = 11.40%
Domestic Equity Growth: [0% × (1 – 0.28)] + 12.5% = 12.50%
Fund
After-tax Annual
Weighted
Funds
Allocation
Return (%)
(%)
Money Market 5 1.80 0.09
Domestic Bond 55 3.74 2.06
Domestic Equity: Income 10 11.40 1.14
Domestic Equity: Growth 30 12.50 3.75
Portfolio Expected Return 7.04
LEVEL III, QUESTION 9
Topic: Portfolio Management-Individual Investor
Minutes: 10
Reading References:
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