QUESTIONS 7, 8, AND 9, INCLUDING GUIDELINE ANSWERS (STUDY SESSION 9...

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: