Question

James Brown wishes to establish a scholarship for disadvantaged university students. The scholarship should generate $150,000 each year (into perpetuity) from a Charity Fund of $2 million. He foresees no further addition to the fund through further donations. James has asked the portfolio manager, JT Investments LLC, to ensure that the capital of the fund is preserved in real terms. He has also asked that the fund invests in developed equity and bond markets only and that the fund does not take additional risks by investing in the derivative markets, or use leverage. James has forecasted that inflation will remain at 1.5% per annum. James also wants to ensure that the volatility of the fund should remain less than 70% of the volatility of US Equities. JT Investments LLC feel that a 60:40 portfolio (60% in equities and 40% in bonds) may be suitable to achieve the investment objectives, and should be considered as a benchmark to achieve. JT Investments LLC have recommended a better diversified portfolio (40% in US equities, 20% in EAFE equities and 40% In US bonds) that they think may improve the ability to achieve the investment objectives.

a) What is the investment objective for this scholarship fund? Your answer must provide a numerical value for required returns (in % terms) and risk objective (in % term). Use results from question 1 above to formulate the risk objective.

b) What are the Investment constraints for this Charity Fund? You must address (i) Liquidity constraints, (ii) Investment Horizon constraints, and (iii) Investor Preferences constraints.

c) Based on the results from Question 1 above, do either portfolios (the 60:40 portfolio and the Recommended portfolio) fulfil the investment objectives? Explain your answer by ensuring that you address return and risk objectives separately.

Answer 1

a) Investment Objective

The Objective of the scholarship fund is to generate $150,000 each year into perpetuity and ensure capital of the fund is preserved in real terms.

Return Objective

Scholarship 150000 / 2000000 = 7.5 %

Inflation (to maintain fund is preserved in real terms) = 1.5 %

Total return = 9%

Risk Objective

1. No investment in derivative market

2. No use of leverage

3. Beta of the portfolio should be less than 0.7

b) Constraints of the scholarship fund

1. Liquidity - Fund must generate annual cash flow of $150000 and should maintain value in real terms

2. Investment Horizon - Fund has a long term investment horizon, there is no need to liquidate the fund it will go on till perpetuity

3. Investor Prefrences - Investor preference is to invest only in cash market (derivative and use of leverage is to be avoided)

c) Both the portfolios fulfill the invetment objectives

Risk Objective - by investing less than 70% in equities portfolio beta will be less than 0.70, there is no use of leverage / investment in derivative market