MBA53048, Portfolio Management

Posted: August 26th, 2021

MBA53048, Portfolio Management

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MBA53048, Portfolio Management

Part 1: Asset Allocation

The Concept of Asset Allocation

Asset allocation refers to an investment strategy whose primary objectives are to balance a project’s reward and risk by altering the distribution of assets in a portfolio. It suits the individual or institution’s risk and reward by apportioning a portfolio’s assets according to its aims, tolerance to risk, and the overall investment horizon(Goldstein, Jiang & Ng, 2017). As such, there are three major categories of assets that an individual or organization can hold. These include equities, cash and equivalents, and fixed-income (Goldstein et al., 2017). The three asset categories have diverse levels of return spectrum and risk. Thus, this implies that they perform differently in different periods.

Importance of Asset Allocation

The concept of asset allocation is crucial to investors. It helpsin analyzing different asset allocation techniques to reach different investment objectives. Also, they use this concept to gauge their savings habit, patterns, and goals in determining the purpose of their savings (Lo et al., 2019). Equally, the investors can be saving for short-term and medium-term objectives such as purchasing a new car and house or for long-term purposes like early retirement. Hence, when an investment risk tolerance is low, investors should not be exposed to equities or less exposed to them since equities fluctuate. However, if they are long term investors, then it should be fine because historically, the DOW and S &P are often green.

Additionally, institutional investors are risk-averse and might not want to invest in long-term strategies and just beat the inflationary rate (Lo et al., 2019). More so, age is a crucial factor when making investment options as young people in their 30’s might want to take more risks while a person in their 60’s close to retirement might want more exposure to bonds and bank deposits because they are deemed as low-risk investments(Goldstein, Jiang & Ng, 2017). At the same time, market conditions play a crucial role in a high or low-interest-rate environment. Thus different investment strategies should be implemented.

Strategies of Asset Allocation

When evaluating asset allocation, it is always a complicated avenue assessing, and digging inside each asset class due to a chain of sub-categories that need to be examined (Fisher et al., 2020; Goldstein, Jiang & Ng, 2017). Equally, when allocating assets, there are two types of stock, namely small and large-cap stocks. The small-cap stocks are considered growing stocks yet highly volatile, while large caps are mature value stocks that with the least potential for growth although highly stable compared to small caps (Fisher, Pettenuzzo & Carvalho, 2020). Investors also consider the country in which they would like to invest in, for example, investing in U.S securities, which are governed by the Security and Exchange Commission (SEC) and a multitude of government entities, which makes for a transparent and safer market(Fisher, Pettenuzzo & Carvalho, 2020). The U.S securities are also considered as having less market manipulation and insider trading than other countries, which areless governed and, therefore, susceptible to market manipulation and insider trading.

Moreover, investors can consider trading in government and corporate bonds, as they are less risky and offer stable returns. The bonds do not have the same rating(Goldstein, Jiang & Ng, 2017). Besides, in most cases, they include third world country government bond that has a high coupon rate with a high risk of default or T-bills that have a minimal chance of default (Fisher, Pettenuzzo & Carvalho, 2020). Consequently, investors should consider factors such as the activeness ofeach portfolio allocation, focusing on the frequency of buying and selling of the individual stocks. As such, investors who buy and hold policies often have their allocation considered static. Thus, when financial security goes down, the investor will rebalance the portfolio by buying more if there is growth in the security grows. In this case, the investor will take out some profit to rebalance the overall allocation(Fisher, Pettenuzzo & Carvalho, 2020). Hence, investors should dynamically change their asset allocation when there are changes in market conditions to seize an opportunity or minimize risks since portfolios’ asset allocation shifts based on demand and supply factors in the market.

The Two Fund Theorem

The theory holds that an investor will contain both a risk-free asset and a market portfolio that consists of all financial assets available in the market to investors. It further states that every asset is held in proportion to its market value relative to the total market value of all assets (Choi et al., 2017). Therefore, investors seek to invest in two efficient portfolios to adverse risk. One of these is the risk-free asset is the fixed income T-bills. A risk-free asset is one whose future value is known with certainty based on its present value(Goldstein, Jiang & Ng, 2017). However, a risky asset or financial security refers to an asset that has high returns, but with uncertain market value. Thus, highly risky.

Risk-Free Asset

It has a definite future return with no possibility of depreciating or becoming worthless altogether. The assets have low return rates as they are safe to invest in, implying investors do not need to be paid a premium for risk-taking (Choi et al., 2017). Additionally, the assets are assured against nominal loss though they are not guaranteed against loss from inflation, leading to a decline in the purchasing power. Hence, the risk-free assets are subjected to reinvestment risk in the long-run.

Optimal Capital Allocation Line (CAL) With a Risk-Free Asset and Two Risky Assets

Several steps and procedures are required to build a portfolio using the capital allocation line (CAL). The optimal portfolio available to an investor in the market comprises of a risk-free asset and a risky asset to hedge investment risk (Vukovic & Prosin, 2018). The ideal risky asset is when the CAL line is tangent with the efficient frontier line. The asset is optimum as at this point, the slope of the CAL line is at the highest implying that the highest additional per unit returns are achieved with every extra risk unit(Fisher, Pettenuzzo & Carvalho, 2020). Therefore, investors adopt both the CAL line and efficient frontier curve to determine and achieve different risk besides returning combinations based on their preference.

Hence, the optimum risky portfolio is located where the CAL line is at a tangent with the efficient frontier curve. The assets weight combination provides the ideal risk-to-reward ratio, which is highest at the slope of the CAL line (Vukovic & Prosin, 2018). Equally, CAL helps investors choose the amounts to invest in risk-free and risky assets. Therefore, the asset allocation concept is allotting funds among different asset types with separate expected returns and risk levels. Still, capital allocation refers to allocating funds between risk-free and risky financial assets, such as T-bills and stocks.

Developing Portfolios in the CAL

A smooth and straight forward technique in adjusting a portfolio’s risk level is to regulate funds invested in risk-free assets. The reason is that the overall set of investment opportunities available to investors in the financial market comprises of a combination of all risky and risk-free assets (Vukovic & Prosin, 2018). Thus, a combination is then graphically plotted on the x and y-axis. The y-axis represents the expected return, while the x-axis is the asset’s risk as denoted by the standard deviation.

Combination withthe Risk-Free Rate

There is a possibility of leveraging or deleveraging in the CAL, which implies using borrowed funds or debts in asset allocation (Vukovic & Prosin, 2018). Thus, when the interest rate on the borrowed funds is higher than the price on risk-free assets, the investment is termed to beincomplete leverage.

The Slope of CAL

It shows the incremental returns on financial assets per incremental risk of the asset. It is referred to as the Sharpe ratio or reward to volatility ratio (Vukovic & Prosin, 2018). The slope of CAL is different when a portfolio has borrowed on a risk-free rate as the CAL is marginally flattened.

Part 2: Portfolio Selection

When selecting an investment portfolio, the best or ideal portfolio is the one with the highest Sharpe ratio, usually at 2.11, once a risk-free rate of 1.25% is factored(Vukovic & Prosin, 2018). The high Sharpe ratio shows that there is a low correlation between the assets in the portfolio. Therefore, it is the best. Hence, combined with respectable return and standard deviation, the graph below explains that there the stock haslow volatility and low risk compared to the rest of the portfolio selection, although with higher expected returns.

Figure 1: Efficient Frontier

Part 3: Measuring the Performance of a Portfolio

Most investors base their investment on returns alone without considering the risk levels of a portfolio. There are three techniques used to measure and quantify risk as well as returns of a portfolio while making an investment decision(Vukovic & Prosin, 2018). Although there is no single perfect tool, a combination of these tools can be adapted to calculate the portfolio risk and consider respective returns. The three measurement tools are the Treynor Measure that measures each stock relative to the benchmark, Sharpe Ratio, and the Jensen measure (Nwogugu, 2018;Vukovic & Prosin, 2018). The tools are implemented by putting together the risk and return performance in a single value. Thus, despite the uniqueness of each tool, they are useful in assessing portfolio risks.

Treynor Performance Measurement Tool

The measure is termed as the reward-to-volatility ratio. It was developed by Jack L. Treynor, whose fundamental objective was to give investors a composite measurement tool of the portfolio’s performance, which included the risk. The goal was to provide a performance measure that can be applied by all financial investors, irrespective of their risk appetite and preferences (Nwogugu, 2018). Therefore, he recommended two risk components of a portfolio; first, the risk from changes in the stock market and second, the risk from individual security variations. Equally, Jack presented the security market line (SML) that defines relationships between portfolio yields and market rates of return. The slope of SML indicates the comparative volatility on the market and stock portfolio represented by beta. The coefficient of the beta represents the portfolio’s volatility to that of the market. Thus, the higher the SML’s slope, the more significant the risk-return(Vukovic & Prosin, 2018). The Treynor performance measure is calculated as follows;

According to the equation, the difference between the portfolio return and risk-free returns indicates the risk premium, while beta is the portfolio risk. Therefore, the value shows the stock portfolio’s performance on every risk unit.

Sharpe Ratio

The ratio is precisely like Treynor measure, though the difference is that the measure of risk is the portfolio’s standard deviation. Besides, the measure goes beyondjust considering the systematic risk of a portfolio represented by beta in the Treynor performance measurement tool(Vukovic & Prosin, 2018; Fisher, Pettenuzzo & Carvalho, 2020). The ratio was developed by Bill Sharpe. It is closely related to the capital asset pricing model (CAPM) as it uses the portfolio’s total risk in the capital market line (CML) (Nwogugu, 2018). The Sharpe ratio is expressed as follows;

Jensen Measure

It is also referred to as alpha 4. The measure was first introduced by Michael C. Jensen. It is calculated by CAPM, giving the excess portfolio return generated above the expected returns (Nwogugu, 2018). The ratio is adjusted on market risk and indicates that the portfolio’s performance is attributed to a company’s management ability to provide the above-average returns. Thus, the greater the ratio,the higher the risk of adjusted returns

Which Measurement Tool Is Better?

Among the three measurement tools, the Sharpe ratio stands out as the best risk assessment took becauseit can examine the portfolio’s total risk in the capital market line (CML) and CAPM. However, this does not imply other tools should not be used.

Part 4: Market Funds in a Portfolio

Which Fund Outperform The Benchmark?

According to the calculations (Excel), the third and fourth funds outperform the index or benchmark (index).

Which Portfolio Offers The Highest Compensation For Risk?

The best value fund based on beta funds one since it is the makes it less risky than the rest of the two funds, which theoretically means it is less risky than the market.

Which Is The Most Consistent Fund Over Time?

The first fund is the most consistent of the four funds.

References

Choi, N., Fedenia, M., Skiba, H., & Sokolyk, T. (2017). Portfolio concentration and performance of institutional investors worldwide. Journal of Financial Economics, 123(1), 189-208.

Fisher, J. D., Pettenuzzo, D., & Carvalho, C. M. (2020). Optimal asset allocation with multivariate Bayesian dynamic linear models. Annals of Applied Statistics, 14(1), 299-        338.

Goldstein, I., Jiang, H., & Ng, D. T. (2017). Investor flows and fragility in corporate bond funds. Journal of Financial Economics, 126(3), 592-613.

Lo, A. W., Matveyev, E., & Zeume, S. (2019). The Risk, Reward, and Asset Allocation of Nonprofit             Endowment Funds. Reward, and Asset Allocation of Nonprofit Endowment Funds (November 1,             2019).

Nwogugu, M. I. (2018). Informationless Trading and Biases in Performance Measurement: Inefficiency of the Sharpe Ratio, Treynor Ratio, Jensen’s Alpha, the Information Ratio, and DEA-Based Performance Measures and Related Measures. In Indices, Index Funds And ETFs (pp. 233-265). Palgrave Macmillan, London.

Vukovic, D. B., & Prosin, V. (2018). The prospective low-risk hedge fund capital allocation line model: evidence from the debt market. Oeconomia Copernicana, 9(3), 419-439.