Question

5. Return and Risk of Portfolio (12%) Mr. Smith's portfolio of $2 million is invested as follows: Summary of Smith's Current Portfolio Annual Percentage of Expected Value Standard Total Annual Return Deviation Short-term Bonds 200,000 10% 4.6% 1.6% Domestic Large-Cap 600,000 30% 12.4% 19.5% Equities Domestic Small Cap 1.200.000 60% 16.0% 29.9% Equities Total Portfolio 2,000,000 100% 13.8% 23.1% Smith soon expects to receive an additional $2 million and plans to invest the entire amount in an index fund that best complements the current portfolio. You, an expert of fund management, are evaluating the four index funds shown in the following table for their ability to produce a portfolio that will meet two criteria relative to the current portfolio: (1) maintain or enhance expected return and (2) maintain or reduce volatility. Each fund is invested in an asset class that is not substantially represented in the current portfolio. Index Fund Characteristics Index Fund Expected Annual Expected An Correlation of Return Returns with Standard Deviation Current Portfolio Fund A 15% 25% +0.8 Fund B 11% -0.6 Fund C 16% 25% -09 Fund D +0.65 State which fund you should recommend to Smith. Justify your choice by describing how your chosen fund best meets both of Smith's criteria. No calculations are required.

Answer 1

I would recommend Index Fund D, my justification is as follow:

Smith is expected to receive $2 million and plans to invest in Index Fund with following two conditions:

1. maintain or enhance expected return
2. maintain or reduce volatility

As per above two conditions if we choose fund A and C, it will increase the return to 15% - 16% then our current portfolio's rate of return i.e. 13.8% but it will increase its volatility as its Standard Deviation is higher i.e. 25% as compared to our current portfolio's standard deviation of 23.1%

Now coming to Fund B and D,

Fund B's expected return is less than out current portfolio's rate of return though it fits the criteria of volatility.

Fund D is recommended as

1. It's expected return is 14% i.e higher than our current portfolio's rate of return.
2. It's standard deviation is 22% i.e. less than our current portfolio's standard deviation of 23.1%.
3. It's correlation of return with current portfolio +0.65 is better than fund B +0.6.

So, I advice to invest in Index Fund D.