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BFF5270 Tutorial Questions

Topic 4 – Asset Allocation

Submission due: 2.00pm on the day of the lecture in Teaching Week 5

(Detailed Unit Schedule in Moodle shows the week numbers)

Note: Tutorial questions are obtained from MTPM =Managing Investment Portfolios: A
Dynamic Process Workbook and SPH-BKM = BFF5270: Funds Management. Work that is
copied from solutions or another student(s) or shared and submitted as your own constitutes
cheating and/or plagiarism and will not earn any marks. Please be aware that BFF5270
teaching staff can use text-matching software such as Turnitin to check for plagiarism.
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SPH-BKM = BFF5270: Funds Management, Chapter 9, p.318

Problems 1, 4 and 5

Problems 1 through to 3 are as above.

Problems 4 onwards are continued below.

4. The Garrett Foundation would like to choose an asset allocation that minimise the probability of
returns below its annual spending rate of 3.5 percent. Based on the data presented in Table 4.1,
recommend an asset allocation for the foundation.

Table 4.1 Investor’s forecasts

Investor’s forecasts
Asset Allocation Expected return Standard deviation of return
A 11.5% 18%
B 8 14
C 6 10

5. You have the following information

Table 5.1 Asset class statistics
Asset Expected Volatility
Return (annual) (annual)
Cash 4% 0%
Equities 8% 7%
Fixed Interest 5% 3%
Inflation Indexed Inflation + 2% 4%
Bonds (IIB)
Inflation (not an 3% 2%
asset of course)

a. Your client is an Insurance Company. Their stated annual return requirement is inflation
+ 2% (before tax) with volatility not greater than 6%. The company only had moderate
liquidity needs. Suggest and defend an SAA for the client. (Assume zero correlations, no
calculations are required)

b. Your client has a funding ratio of 1.1, and their liabilities are expected to grow at
inflation + 1%. On an ALM basis how would this impact their SAA?

c. Your client now has a funding ratio of 0.6 (assuming same liabilities as in b above). How
would this now affect their SAA?

d. Explain the formal process in creating a SAA.

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6.
Louise and Christopher Maclin live in London, United Kingdom, and currently rent an
apartment in the metropolitan area. Christopher Maclin, aged 40, is a supervisor at Barnett Co.
and earns an annual salary of £80,000 before taxes. Louise Maclin, aged 38, stays home to care
for their newborn twins. She recently inherited £900,000 (after wealth-transfer taxes) in cash
from her father’s estate. In addition, the Maclins have accumulated the following assets (current
market value):
• £5,000 in cash
• £160,000 in stocks and bonds
• £220,000 in Barnett common stock
The value of their holdings in Barnett stock has appreciated substantially as a result of the
company’s growth in sales and profits during the past 10 years. Christopher Maclin is confident
that the company and its stock will continue to perform well. The Maclins need £30,000 for a
down payment on the purchase of a house and plan to make a £20,000 non-tax-deductible
donation to a local charity in memory of Louise Maclin’s father. The Maclins’ annual living
expenses are £74,000. After-tax salary increases will offset any future increases in their living
expenses.
During discussions with their financial adviser, Grant Webb, the Maclins express concern about
achieving their educational goals for their children and their own retirement.
Webb has prepared the following investment policy statement for the Maclins.

A i. The Maclins’ overall risk objective must consider both willingness and ability to take
risk:
Willingness. The Maclins have a below-average willingness to take risk, based on their
unhappiness with the portfolio volatility they have experienced in recent years
and their desire not to experience a loss in portfolio value in excess of 12 percent
in any one year.
Ability. The Maclins have an average ability to take risk. Although their fairly
large asset base and long time horizon in isolation would suggest an above-
average ability to take risk, their living expenses of £74,000 are significantly
higher than Christopher’s after-tax salary of £80,000 (1 − 0.40) = £48,000
causing them to be very dependent on projected
portfolio returns to cover the difference and thereby reducing their ability
to take risk.
Overall. The Maclins’ overall risk tolerance is below average, as their below- average
willingness to take risk dominates their average ability to take risk in
determining their overall risk tolerance.
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ii. The Maclins’ return objective is to grow the portfolio to meet their educational and
retirement needs as well as to provide for ongoing net expenses. The Maclins will
require annual after-tax cash flows of £26,000 (calculated below) to cover ongoing net
expenses and will need £2 million in 18 years to fund their children’s education and their
retirement. To meet this objective, the Maclins’ pretax required return is 7.38 percent
which is determined below.
The after-tax return required to accumulate £2 million in 18 years beginning with an
investable asset base of £1,235,000 (calculated below) and with annual outflows of
£26,000 is 4.427 percent, which when adjusted for the 40 percent tax rate, results in a
7.38 percent pretax return (4.427%/(1 − 0.40) = 7.38%).

Christopher’s annual salary £80,000

Less: taxes (40%) −32,000
Living expenses −74,000
Net annual cash flow −£26,000
Inheritance 900,000
Barnett Co. common stock 220,000
Stocks and bonds 160,000
Cash 5,000
Subtotal £1,285,000
Less one-time needs:
Down payment on house −30,000 Charitable donation
−20,000
Investable asset base £1,235,000

Note: No inflation adjustment is required in the return calculation because increases in

living expenses will be offset by increases in Christopher’s salary.

B. The Maclins’ investment policy statement includes the following constraints:

i. Time horizon. The Maclins have a two-stage time horizon, because of their
changing cash flow and resource needs. The first stage is the next 18 years. The second
stage begins with their retirement and the university education years for their children.
ii. Liquidity requirements. The Maclins have one-time immediate expenses totaling
£50,000 that include the deposit on the house they are purchasing and the
charitable donation in honor of Louise’s father.
iii. Tax concerns. A 40 percent tax rate applies to both ordinary income and capital gains.
iv. Unique circumstances. The large holding of the Barnett Co. common stock
represents almost 18 percent of the Maclins’ investable asset base. The concentrated holding
in Barnett Co. stock is a key risk factor of the Maclins’ portfolio and achieving better
diversification will be a factor in the future management of the Maclins’ assets.
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The Maclins’ desire not to invest in alcohol and tobacco stocks is another constraint on
investment.

The background to this question is as given above. You are required to provide
answers to Parts a and b shown below.
Louise and Christopher Maclin have purchased their house and made a donation to the local
charity. Now that an investment policy statement has been prepared for the Maclins, Grant
Webb recommends that they consider the strategic asset allocation described in Table 6.1.
Table 6.1 Recommended strategic asset allocation
Asset Class Recommende Current Projected Expected
d Allocation Yield Annualized Standard
pre-tax total Deviation
return
Cash 15.0% 1.0% 1.0% 2.50%
U.K. corporate bonds 55.0 4.0 5.0 11.0
U.K. small-cap equities 0.0 0.0 11.0 25.0
U.K. large-cap equities 10.0 2.0 9.0 21.0
U.S. equities 5.0 1.5 10.0 20.0
Barnett Co. common stocks 15.0 1.0 16.0 48.0
Total Portfolio 100 - 6.7 12.4

a. Identify aspects of the of the recommended asset allocation in Table 6.1 that are
inconsistent with the Maclins’ investment objectives and constraints. Support your
reasons.

b. After further discussion, Webb and the Maclins agree that any suitable strategic asset
allocation will include 5 to 10% in U.K. small-cap equities and 10 to 15% in U.K. large
cap equities. For the remainder of the portfolio, Webb is considering the asset class
ranges described in Table 6.2. Recommend the most appropriate allocation range for
each of the asset classes in Table 6.2. Justify each appropriate allocation range with a
reason based on the Maclin’s investment objectives and constraints.

Table 6.2 Asset class ranges

Asset class Allocation ranges

Cash 0%–3% 5% –10% 15% –20%
U.K. corporate bonds 10% –20% 30% –40% 50% –60%
U.S. equities 0% –5% 10% –15% 20% –25%
Barnett Co. Common stocks 0% –5% 10% –15% 20% –25%
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7. In Figure 7.1, if Frontier A is a mean-variance efficient frontier in which the efficient portfolios’
portfolio weights reflect perfect knowledge of the true return parameters (the best attainable),
discuss whether Frontier B could be

a. The conventional mean-variance efficient frontier

b. The resampled efficient frontier

Hint: In Markowitz portfolio theory, a portfolio is “efficient” if it has the best possible expected
level of returns for its level of risk.

Figure 7.1 Efficient Frontiers

Expected returns
Frontier B

Frontier A

Std. deviation of returns