An investor who had invested for almost 2 decades had not pursued investing in the US market since the 2008-2009 financial crisis. In 2017, the investor was considering reshuffling the investment portfolio to focus more on the US market. This case study shows the expected returns and risks the investor should consider before making his move.
Weina Zhang; Man Zhang; Ruth S.K. Tan; Zsuzsa R. Huszar
Harvard Business Review (W18632-PDF-ENG)
October 09, 2018
Case questions answered:
We have uploaded two case solutions, which both answer the following questions:
- Analyze the expected return from your investment after taking into account your family’s financial needs in the next five years.
- Conduct a Markowitz portfolio analysis on the 10 ETFs recommended by your broker, using annual historical returns and risks to determine the optimal portfolio allocation. Discuss the diversification benefit by comparing the performance of investing in individual ETFs and the efficient frontier. (Hint: The one-year risk-free rate was 0.87 percent in December 2016 using the one-year Treasury bill rate shown in case Exhibit 2, panel B).
- Conduct a Markowitz portfolio analysis on the 10 ETFs recommended by your broker, using annualized three-year historical returns and risks to determine the new efficient frontier. Discuss the long-term investing benefits by comparing this efficient frontier with the efficient frontier determined in question 2.
- Based on the market risk premium forecasted by J. P. Morgan in case Exhibit 3, panel B, determine whether a tactical asset allocation would enable you to earn a higher return in the following year. You might need to adjust the allocation made in question 2.
- Analyze the quantitative and qualitative advantages and disadvantages of adding two alternative investment vehicles to the optimal portfolio. The two alternative asset classes include gold and real estate investment trusts that are traded in the U.S. market and denominated in U.S. dollars. The historical annual index levels of the two ETFs are available in case Exhibit 4.
- Make a final optimal investment decision after taking into account the above analyses.
- Discuss the weaknesses and vulnerabilities of applying the Markowitz Portfolio Theory in practice.
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Case answers for Strategic Asset Allocation During Global Uncertainty
This case solution includes an Excel file with calculations.
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Executive Summary – Strategic Asset Allocation During Global Uncertainty
In Singapore, during January 2017, someone is assumed to be an investor who has been holding the investment portfolio. It has not been doing well in the past period. Seeing the investment opportunity due to policy changes benefits in U.S. country, the selection of 10 exchange-traded funds (ETFs) listed and traded on the Singapore Stock Exchange were offered by the broker. These funds are comprised of six equities and four bonds based in various countries. Considering to reshuffle and start putting more weights into U.S. securities, given the changes in the significant scene, we have to analyze the expected returns and risk of these offered ETFs.
This report provides the strategies of asset allocation, including the advantage of diversification and the management of macroeconomic risk exposures. To determine the optimal method for portfolio investment during global uncertainty, starting with the situation facing at the beginning of 2017, followed by investment planning to construct a portfolio and evaluate their merits and vulnerabilities, we decide to apply the theory of mean-variance optimization (MVO) which relies heavily on return forecasts and risk adjustment from asset allocation, following with the description of Markowitz portfolio theory in practice.
Finally, to analyze the alternative approaches to exceed the required return derived from the situation, strategic asset allocation with longer investment time horizon and alternative investment vehicles added to the optimal portfolio is preferable. However, it is also based on several factors, such as the investor’s risk aversion, and investment objective.
Situation – External Economic & Financial Needs
Assumed as an investor who had been investing for some periods with a mere return of 2%, he found the investment opportunity due to expected global changes. In spite of a large number of losses resulting from the global financial crisis occurred in 2009, the investor is now considering whether to re-allocate his portfolio and put more weight on U.S. securities. Consequently, he wished to revise his investment strategies by reconsidering how much to allocate his money among the existing ten exchange-traded funds offered by the broker, seen in Exhibit 1.
In addition, the investor has to provide the additional cash flows for his two daughters’ college tuition fees in the future. The total expected expenses of college tuition are approximately S$30,000 per year for three years. On the other hand, his net salary saved from his career for the next five years is around $10,000 per year.
According to the past investment experience ( about 20 years ago), the investor started to invest with an initial sum of $100,000. As a result, over the years, his investment value becomes higher, approximately $500,000.
Market Outlook (2017) & Assumptions
As can be seen in Exhibit 2, there was an impact on global financial markets. This mostly resulted from significant geopolitical surprises in the U.S. (Nov 2016).
Analysis & Theory
Before exploring the analysis and considering to reshuffle the investment portfolio, it is useful to identify the required return needed to exceed. To derive this figure, the cash flow timeline could be constructed as follow:
- Started from the past investment, compound yearly rate of return is derived by using the formula :
- To derive the figure of required return which is aimed to achieve, the cash flow timeline could be constructed as follow :(More explanation in Exhibit 3)
As can be seen, the required return calculated from IRR (Internal rate of return) is approximately 3.183%. This is the expected return from an investment after taking into account the family’s financial needs in the next five years. Consequently, the investor can perform a…