Investment Portfolios Final Project FN480 –
Maginn, J., Tuttle, D., McLeavey, D., & Pinto, J. (2007). Managing investment portfolios: A dynamic process (3rd ed.). Hoboken, New Jersey: John Wiley & Sons.
Assessment:Summarize Types of Investment Strategies and their Related Uses.
For this project you will suppose that you have just won a $200,000 tax-free award to be paid to you immediately. The stipulations on this award are as follows:
· You are not allowed to access the principal value until retirement. (Or, if you are already retired, for ten years).
· You are allowed to access earningsfrom interest, dividends, or realized capital gains at any time.
· You are allowed to make risky investments that could cause the value of the principal to fall below $200,000.
You will write an investment policy and devise consistent investment strategies to manage this $200,000 portfolio. Although the funds are imaginary, you should write the policies and strategies as realistically as possible for your own household.
A. Write your investment policy statement
Follow the guidelines in the text regarding portfolio objectives and investment policy statements. Specifically, your statement must include:
I. Background: An introduction giving the relevant background for your household.
II. Return Objectives: Include both qualitative descriptions (explanations in words) and matching quantitative objectives (numbers with supporting math). Explain these objectives.
III. Risk Tolerance: Discuss your willingness to take risk, and your ability to take risk. Include qualitative descriptions and the numerical risk measures we have learned about. List and explain specific factors that increase or decrease your risk tolerance.
IV. Constraints: Discuss and explain your liquidity requirements, time horizon, tax concerns, and any other constraints or unique circumstances.
V. Eligible Asset Classes and Target Weights: Based on your return objectives, risk tolerance, and constraints, list the asset classes that will comprise your portfolio, and give target weights with allowable ranges. Explain and justify these choices. Your portfolio must have some type of exposure to equities, fixed income, foreign securities, and at least one other asset class.
Each section must be accompanied by a thorough explanation of how and why it is appropriate for your household. Your explanations must demonstrate that you understand the related concepts from the course. If calculations are needed (for example, to find your required return), show work within the body of the paper or as an appendix.
B. Select securities for the portfolio and perform a portfolio analysis.
Create a portfolio that is consistent with your investment policy statement, contains at least ten securities, and has some type of exposure to equities, fixed income, foreign securities, and at least one alternative asset class.Hint: You should definitely use mutual funds and exchange-traded funds for exposure to different asset classes. Direct investments into assets like gold or real estate will make it difficult to produce the information required below.
Create a spreadsheet showing the following:
· Each security, and the amount invested in that security.
· The yield (dividend, or otherwise) of each security.
· Your estimate of the expected return for each security, and the weighted expected return for the portfolio.
· The standard deviation of each security, and the standard deviation of the portfolio.
· A table ofcorrelations between each pair of assets.
*Help for finding expected returns, standard deviations, and correlations is in an appendix at the end of this document, as well as in an Excel spreadsheet that you will receive separately.
C. Demonstrate the portfolio’s suitability
Use all of the above information to carefully demonstrate how your portfolio is consistent with your investment policy statement from Part A and the best practices of portfolio construction. Specifically:
· Prove that your portfolio is likely to meet your return objectives, including the numerical return objectives, given in Part A. In addition, justify the values you used for expected returns in Part B.
· Prove that your portfolio meets your risk objectives, including the numerical risk objectives, given in Part A. In addition, justify the values you used for standard deviations in Part B. Also demonstrate that your portfolio is diversified, using the appropriate measures.
· Prove that your portfolio meets your target weights and any other constraints you described in Part A.
D. Portfolio Strategy Discussion
Answer the following portfolio strategy questions. Explain the relevant strategies in detail. Be sure to demonstrate an understanding of the related course concepts.Each answer should be at least a solid paragraph.Some answers will need more than one paragraph to be complete.
1. Is your overall strategy passive, active, or something else? Explain.
2. Did you use indexing, use actively managed funds, or pick individual securities? Why? How did you decide which index, funds, or securities to use?
3. Have you completely used a strategic asset allocation, or are there elements of tactical asset allocation or other strategies?
4. Does your portfolio fit any particular style such as growth or value?
5. Which alternative investments did you include? Why these?
6. What monitoring strategies will you use? What elements will you be monitoring?
7. Which rebalancing strategy will you use? Be specific. Explain.
8. How will you measure the performance of your portfolio? Explain these measures.
Presentation (14 PAGES)
You will submit one MSWord document containing the following:
· Your investment policy statement with accompanying explanations, with all requirements described in part A.
· Your portfolio with the information required in part B. If you cannot paste your Excel information into Word in a professional manner, then you may attach your Excel spreadsheet separately.
· The explanations of your portfolio’s suitability as required in part C.
· Answers to the portfolio strategy discussion questions in part D.
Your presentation must be professional in appearanceand free from language errors. Your presentation must also be clearly labeled to distinguish each part. Use appropriate headings and subheadings. You will lose points if it is not clear howthe parts of your presentation match up to the project requirements.
All papers should be formatted in the following manner:
2. Times New Roman, 12-point font
3. 1-inch margins (all sides)
4. Include Title Page
5. Include Reference Page
a. References must be in alphabetical order and in proper APA format (double-spaced with hanging indents)
b. APA resources:
c. APA citation should be used whenever sources are cited
APPENDIX: Finding Information Needed to Create a Portfolio
The website assetcorrelation.com is a good tool to find correlations. Click the “Correlations” tab, and the click the “Time” sub-tab. Enter two ticker symbols and change the time to 5 years. This will produce a graph of the correlation between the two assets over the last 5 years. You will see that the correlation fluctuates, which is a challenge in the portfolio creation process. Use your best estimate (such as the average value in the graph) for the correlation.
If you wish to create a free account at assetcorrelation.com, you can then enter your portfolio and get a table of all the correlations at once. If you do this, look under the table for “Select Period” and choose the longest period available.
Finding Standard Deviations
For any type of fund, go to Morningstar.com, get a quote, and click the “Ratings & Risk” tab. The standard deviation will be listed.
For an individual stock, copy a list of annual historical prices into Excel, and use the =STDEVP( ) formula. Historical prices can be found many places, but one easy place is at Morningstar.com. Get a quote, click the “Performance” tab, then the “Price History” sub-tab, set the date range to “Max” and the frequency to “Yearly.” Use the close prices.
Finding a Portfolio Standard Deviation
Remember that a portfolio standard deviation is NOT the average of the individual standard deviations. You will receive an Excel spreadsheet to help you calculate a portfolio standard deviation. Follow the instructions on the Instructions tab to calculate the portfolio standard deviation.
Estimating Expected returns
Method 1: Historical
If you have a long time horizon, then it is acceptable to use a long-term average historical return as an expected return when your investment matches a major asset class. For example, for almost any standard U.S. large-cap mutual fund, 9.9% would be acceptable to use as an expected return. These are geometric mean returns for the period 1926 through 2010:
Large company stocks 9.9%
Small company stocks 12.1%
Long term corporate bonds 5.9%
Long term government bonds 5.5%
Intermediate term government bonds 5.4%
U.S. Treasury bills (short term) 3.6%
These have less of a history:
EAFE index (World developed markets, 1970-2010) 10.1%
Equity REITs (1972-2010) 12.0%
You can also make some reasonable interpolations from the above data. For example, a mid-cap stock fund should be between the 9.9% and the 12.1%. High yield (lower grade) corporate bonds may be 1% to 2% above the 5.9% for investment grade bonds.
Method 2: Beta and CAPM
Another method is to use the CAPM equation:
Expected return = Risk Free Rate + Beta (Expected Benchmark Return – Risk Free Rate)
· Betas can be found at almost any online financial site. However, you do need to find a source that specifies which index the beta is being measured against. For example, the iShares site says, “Beta versus S&P 500.”
· The expected benchmark return would be for the index being used to measure beta.
· U.S. Treasury bills are usually used for the risk free rate.
Example: The S&P GSCI Commodity-Indexed Trust (Ticker: GSG) has a beta of 1.13 against the S&P 500. Using 3.6% for the risk free rate (the historical average for Treasury bills), and 9.9% for the expected benchmark return (the S&P 500 is for large stocks), we get: Expected return = 3.6 + 1.13 (9.9 – 3.6) = 10.7%
Method 3: Estimate based on standard deviation
In the long run, expected return should have a direct relationship to standard deviation (risk). The risk/return relationship can be approximated by:
Expected return = 3.6 + 0.405*standard deviation
Example: The iShares S&P Global 100 Index (Ticker: IOO) has a standard deviation of 17.01. The expected return is approximately 3.6 + 0.405*17.01 = 10.5%.
Finding the Expected Return of a Portfolio
The expected return of a portfolio is the weighted average of the individual expected returns. For each asset in the portfolio, multiply its expected return by its weight in the portfolio. Then, add up the results to get the expected return of the portfolio.
Other Helpful Resources
ETFs for stocks, bonds, foreign investments, alternative assets. Includes standard deviations of these funds.
Enter your portfolio and get summary data about it, including styles.
Suggested asset allocations. If you use these sites, you must still completely justify your choices, beyond “because that’s what the asset allocation website said.”
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