Asset Allocation for Hawksville College: A Performance Analysis

Performance Analysis of Existing Asset Allocation

Simpson was concerned about the economic outlook for small colleges like Hawksville College. He anticipated the need to continue relying on the endowment fund in the coming years. He also felt strongly that a return of 1% per month represented a floor below which the portfolio return should not drop. He wanted Muffett to suggest an efficient asset allocation to achieve this goal. Last, but not least, Simpson wanted to know whether the  board should concern themselves with fundamental questions such as whether the endowment fund is adequate for the school's future needs. Can they continue with their present allocation policy? What if the enrollment continues to decline?

Based upon her consultations with Simpson, Muffett has drawn up a list of issues that need to be addressed. She has decided to hire your group for this task. You are required to address the following questions. In your analysis assume that short-sales are allowed (except when explicitly ruled out) and borrowing at the risk-free rate is possible.

1. How well did the Hawksville College fund perform with its existing asset allocation over the 1972-2006 period? Provide performance statistics, including the annualized mean returns, standard deviation, and Sharpe ratio of the portfolio mix. Also, provide  the performance statistics for the value-weighted market portfolio (VWRETD), the S&P500 index, the Corporate Bond index (CBOND), and the Government Bond index (GBOND) over the same period. Assume the same asset allocation during each month of the holding period.

2. Plot the portfolio frontier given only the five risky assets in which the college is investing. Allow short sales when developing this frontier.

3. Is the portfolio of risky assets currently chosen by the college’s fund manager an efficient portfolio? If not, calculate the investment proportions in the five risky assets chosen by the fund required to construct an efficient risky portfolio that would deliver the same expected return as the current choice of risky portfolio. For this part, assume there is no risk-free investment undertaken by the fund.

4. Calculate the investment proportions required to achieve the optimal (tangency) portfolio with the five risky assets, given the possibility of investing in risk-free T-bills. Calculate the expected return and standard deviation of the tangency portfolio.

5. Continue to assume that you can invest in the risk-free asset. Calculate the investment proportions required to construct an efficient portfolio with an expected return equal to the existing portfolio’s expected return. Also calculate the expected standard deviation of returns on this portfolio.

6. Continue to assume that you can invest in the risk-free asset. Suggest an efficient portfolio allocation to achieve the college's objective of a floor rate of return equal to 1% per month. Also calculate the expected standard deviation of such a portfolio.

7. Simpson is interested in knowing if the college should diversify its portfolio holdings by including real estate (represented by Equity REITs), international stocks (represented by the MSCI EAFE index which includes stocks from Europe, Asia, and the Far East), and precious metals (denoted PM) in its portfolio. Make a case for or against the inclusion of these alternative assets in the college's overall portfolio. Justify your decision by depicting the portfolio frontier in the presence of the eight risky assets vs. the earlier five risky assets. Ignore the risk-free asset in this part. Calculate the efficient portfolio allocations required to achieve the ‘floor’ rate of return of 1% per month with this expanded universe of assets. Also calculate the expected standard deviation of such a portfolio.

8. The calculations thus far make several assumptions regarding investment policy that are not allowed for the typical college fund. For this next part, assume that: 1. You cannot take any short positions in risky assets. 2. You cannot invest more than 30% of the total risky investment in any one asset category. Now calculate the efficient portfolio allocations required to achieve the ‘floor’ rate of return of 1% per month. Also calculate the expected standard deviation of such a portfolio.

9. Present a forceful argument for using your services. Make a few succinct points that might help sway a board member skeptical of asset allocation methods. This member believes that individual stock selection is more important than asset allocation.