1-CHAPTER26:HEDGEFUNDSPROBLEMSETSNo,amarket-neutralhedgefundwouldnotbeagoodcandidateforaninvestor’sentireretirementportfoliobecausesuchafundisnotadiversifiedportfolio.Theterm‘market-neutral’referstoaportfoliopositionwithrespecttoaspecifiedmarketinefficiency.However,therecouldbearoleforamarket-neutralhedgefundintheinvestor’soverallportfolio;themarket-neutralhedgefundcanbethoughtofasanapproachfortheinvestortoaddalphatoamorepassiveinvestmentpositionsuchasanindexmutualfund.Theincentivefeeofahedgefundispartofthehedgefundcompensationstructure;theincentivefeeistypicallyequalto20%ofthehedgefund’sprofitsbeyondaparticularbenchmarkrateofreturn.Therefore,theincentivefeeresemblesthepayofftoacalloption,whichismorevaluablewhenvolatilityishigher.Consequently,thehedgefundportfoliomanagerismotivatedtotakeonhigh-riskassetsintheportfolio,therebyincreasingvolatilityandthevalueoftheincentivefee.Thereareanumberoffactorsthatmakeithardertoassesstheperformanceofahedgefundportfoliomanagerthanatypicalmutualfundmanager.Someofthesefactorsare:Hedgefundstendtoinvestinmoreilliquidassetssothatanapparentalphamaybeinfactsimplycompensationforilliquidity.Hedgefunds’valuationoflessliquidassetsisquestionable.Survivorshipbiasandbackfillbiasresultinhedgefunddatabasesthatreportperformanceonlyformoresuccessfulhedgefunds.Hedgefundstypicallyhaveunstableriskcharacteristicsmakingperformanceevaluationthatdependsonaconsistentriskprofileproblematic.Taileventsskewthedistributionofhedgefundoutcomes,makingitdifficulttoobtainarepresentativesampleofreturnsoverrelativelyshortperiodsoftime.Theproblemofsurvivorshipbiasisthatonlythereturnsforsurvivorswillbereportedandtheindexreturnwillbebiasedupwards.Backfillbiasresultswhenanewhedgefundisaddedtoanindexandthefund’shistoricalperformanceisaddedtotheindex’shistoricalperformance.Theproblemisthatonlyfundsthatsurvivedwillhavetheirperformanceaddedtotheindex,resultinginupwardbiasinindexreturns.TheMerrillLynchHighYieldindexmaybethebestindividualmarketindexforfixedincomehedgefundsandtheRussell3000maybetheindividualmarketindexforequityhedgefunds.However,acombinationofindexesmaybethebestmarketindex,asithasbeenfoundthatmultifactormodeldothebestinexplaininghedgefundreturns.Ofequityhedgefunds,marketneutralstrategiesshouldhaveareturnthatisclosesttorisk-free,buttheyarenotriskfree.Fundoffundsareusuallyconsideredgoodchoicesforindividualinvestorsbecausetheyofferdiversificationandusuallymoreliquidity.Oneproblemwithfundoffundsisthattheyusuallyhavelowerreturns.Thisisaresultfromboththeadditionallayeroffeesandcashdrag(resultingfromthedesireforliquidity).Oftheequityhedgefunds,marketneutralstrategiesshouldhaveareturnthatisclosesttorisk-free,however,theyarenotcompletelyrisk-free.No,statisticalarbitrageisnottruearbitragebecauseitdoesnotinvolveestablishingrisk-freepositionsbasedonsecuritymispricing.Statisticalarbitrageisessentiallyaportfolioofriskybets.Thehedgefundtakesalargenumberofsmallpositionsbasedonapparentsmall,temporarymarketinefficiencies,relyingontheprobabilitythattheexpectedreturnforthetotalityofthesebetsispositive.Managementfee=0.02×$1billion=$20millionPortfoliorateIncentivefeeIncentivefeeTotalfeeTotalfeeofreturn(%)(%)($million)($million)(%)-5 0 0 20 20 0 0 20 25 0 0 20 210 20 10 30 3Theincentivefeeistypicallyequalto20%ofthehedgefund’sprofitsbeyondaparticularbenchmarkrateofreturn.However,ifafundhasexperiencedlossesinthepast,thenthefundmaynotbeabletochargetheincentivefeeunlessthefundexceedsitsprevioushighwatermark.Theincentivefeeislessvaluableifthehighwatermarkis$67,ratherthan$66.Withahigh-watermarkof$67,thenetassetvalueofthefundmustreach$67beforethehedgefundcanassesstheincentivefee.Thehigh-watermarkforahedgefundisequivalenttotheexercisepriceforacalloptiononanassetwithacurrentmarketvalueequaltothenetassetvalueofthefund.a. First,computetheBlackScholesvalueofacalloptionwiththefollowingparameters:S0=62X=66R=0.04σ=0.50T=1yearTherefore:C=$11.685Thevalueoftheannualincentivefeeis:0.20×C=0.20×$11.685=$2.337b. HereweusethesameparametersusedintheBlack-Scholesmodelinpart(a)withtheexceptionthat:X=62Now:C=$13.253Thevalueoftheannualincentivefeeis0.20×C=0.20×$13.253=$2.651c. HereweusethesameparametersusedintheBlack-Scholesmodelinpart(a)withtheexceptionthat:X=S0×e0.04=62×e0.04=64.5303Now:C=$12.240Thevalueoftheannualincentivefeeis0.20×C=0.20×$12.240=$2.448d. HereweusethesameparametersusedintheBlack-Scholesmodelinpart(a)withtheexceptionthat:X=62andσ=0.60Now:C=$15.581Thevalueoftheannualincentivefeeis0.20×C=0.20×$15.581=$3.116a. Thespreadsheetindicatesthattheend-of-monthvaluefortheS&P500inSeptember1977was96.53,sotheexercisepriceoftheputwrittenatthebeginningofOctober1977wouldhavebeen:0.95×96.53=91.7035AttheendofOctober,thevalueoftheindexwas92.34,sotheputwouldhaveexpiredoutofthemoneyandtheputwriter’spayoutwaszero.SinceitisunusualfortheS&P500tofallbymorethan5percentinonemonth,allbuttenofthe120monthsbetweenOctober1977andSeptember1987wouldhaveapayoutofzero.ThefirstmonthwithapositivepayoutwouldhavebeenJanuary1978.TheexercisepriceoftheputwrittenatthebeginningofJanuary1978wouldhavebeen:0.95×95.10=90.3450AttheendofJanuary,thevalueoftheindexwas89.25(morethana6%decline),sotheoptionwriter’spayoutwouldhavebeen:90.3450–89.25=1.0950Theaveragegrossmonthlypayoutfortheperiodwouldhavebeen0.2437andthestandarddeviationwouldhavebeen1.0951.b. InOctober1987,theS&P500decreasedbymorethan21%,from321.83to251.79.TheexercisepriceoftheputwrittenatthebeginningofOctober1987wouldhavebeen:0.95×321.83=305.7385AttheendofOctober,theoptionwriter’spayoutwouldhavebeen:305.7385–251.79=53.9485TheaveragegrossmonthlypayoutfortheperiodOctober1977throughOctober1987wouldhavebeen0.6875andthestandarddeviationwouldhavebeen5.0026.Apparently,tailriskinnakedputwritingissubstantial.a. InordertocalculatetheSharperatio,wefirstcalculatetherateofreturnforeachmonthintheperiodOctober1982-September1987.TheendofmonthvaluefortheS&P500inSeptember1982was120.42,sotheexercisepricefortheOctoberputis:0.95×120.42=114.3990SincetheOctoberendofmonthvaluefortheindexwas133.72,theputexpiredoutofthemoneysothatthereisnopayoutforthewriteroftheoption.Therateofreturnthehedgefundearnsontheindexisthereforeequalto:(133.72/120.42)–1=0.11045=11.045%(continuedonnextpage)Assumingthatthehedgefundinveststhe$0.25millionpremiumalongwiththe$100millionbeginningofmonthvalue,thentheendofmonthvalueofthefundis:$100.25million×1.11045=$111.322millionTherateofreturnforthemonthis:($111.322/$100.00)–1=0.11322=11.322%ThefirstmonththattheputexpiresinthemoneyisMay1984.TheendofmonthvaluefortheS&P500inApril1984was160.05,sotheexercisepricefortheMayputis:0.95×160.05=152.0475TheMayendofmonthvaluefortheindexwas150.55,andthereforethepayoutforthewriterofaputoptionononeunitoftheindexis:152.0475–150.55=1.4975Therateofreturnthehedgefundearnsontheindexisequalto:(150.55/160.05)–1=-0.05936=–5.936%Thepayoutof1.4975perunitoftheindexreducesthehedgefund’srateofreturnby:1.4975/160.05=0.00936=0.936%Therateofreturnthehedgefundearnsisthereforeequalto:–5.936%–0.936%=–6.872%Theendofmonthvalueofthefundis:$100.25million×0.93128=$93.361millionTherateofreturnforthemonthis:($93.361/$100.00)–1=–0.06639=–6.639%FortheperiodOctober1982-September1987:Meanmonthlyreturn=1.898%Standarddeviation=4.353%Sharperatio=(1.898%–0.7%)/4.353%=0.275 b. FortheperiodOctober1982-October1987:Meanmonthlyreturn=1.238%Standarddeviation=6.724%Sharperatio=(1.238%–0.7%)/6.724%=0.080a. SincethehedgefundmanagerhasalongpositionintheWaterworksstock,heshouldsellsixcontracts,computedasfollows:$2,000,000×0.75=6contracts$2501,000×Thestandarddeviationofthemonthlyreturnofthehedgedportfolioisequaltothestandarddeviationoftheresiduals,whichis6%.Thestandarddeviationoftheresidualsforthestockisthevolatilitythatcannotbehedgedaway.Foramarket-neutral(zero-beta)position,thisisalsothetotalstandarddeviation.Theexpectedrateofreturnofthemarket-neutralpositionisequaltotherisk-freerateplusthealpha:0.5%+2.0%=2.5%Weassumethatmonthlyreturnsareapproximatelynormallydistributed.Thez-valueforarateofreturnofzerois:?2.5%/6.0%=?0.4167Therefore,theprobabilityofanegativereturnis:N(?0.4167)=0.3385a. Theresidualstandarddeviationoftheportfolioissmallerthaneachstock’sstandarddeviationbyafactorof100=10or,equivalently,theresidualvarianceoftheportfolioissmallerbyafactorof100.So,insteadofaresidualstandarddeviationof6%,residualstandarddeviationisnow0.6%.Theexpectedreturnofthemarket-neutralpositionisstillequaltotherisk-freerateplusthealpha:0.5%+2.0%=2.5%Nowthez-valueforarateofreturnofzerois:?2.5%/0.6%=?4.1667Therefore,theprobabilityofanegativereturnis:N(?4.1667)=0.0000155Anegativereturnisveryunlikely.a.Forthe(nowimproperly)hedgedportfolio:Variance=(0.252×52)+62=37.5625Standarddeviation=6.129%SincethemanagerhasmisestimatedthebetaofWaterworks,themanagerwillsellfourS&P500contracts(ratherthanthesixcontractsinProblem6):$2,000,000×0.50=4contracts$2501,000×Theportfolioisnotcompletelyhedgedsotheexpectedrateofreturnisnolonger2.5%.Wecandeterminetheexpectedrateofreturnbyfirstcomputingthetotaldollarvalueofthestockplusfuturesposition.Thedollarvalueofthestockportfoliois: $2,000,000×+(1 rportfolio)=$2,000,000 [1 0.005×+0.75 (rM+0.005)× ?0.02 e]+ =$2,042,500 $1,500,000+ rM $2,000,000×+ e ×Thedollarproceedsfromthefuturespositionequal:4×$250×(F0?F1)=$1,000[(S×01.005)×S1?]=$1,000S0××[1.005(1?+rM)] =$1,0001,000× [0.005× ?rM] =$5,000? $1,000,000× rMThetotalvalueofthestockplusfuturespositionattheendofthemonthis:$2,047,500+($1,500,000?$1,000,000)×rM+$2,000,000×e =$2,047,500 $500,000+ (0.01)×$2,000,000+ e×=$2,052,500+$2,000,000×eTheexpectedrateofreturnforthe(improperly)hedgedportfoliois: ($,2052,500/$2,000,000)?=1 .02625 2.625=%Nowthez-valueforarateofreturnofzerois:?2.625%/6.129%=?0.4283Theprobabilityofanegativereturnis:N(?0.4283)=0.3342Here,theprobabilityofanegativereturnissimilartotheprobabilitycomputedinProblem14.Thevarianceforthediversified(butimproperlyhedged)portfoliois:(0.252×52)+0.62=1.9225Standarddeviation=1.3865%Thez-valueforarateofreturnofzerois:?2.625%/1.3865%=?1.8933Theprobabilityofanegativereturnis:N(?1.8933)=0.0292TheprobabilityofanegativereturnisnowfargreaterthantheresultwithproperhedginginProblem15.Themarketexposurefromimproperhedgingisfarmoreimportantincontributingtototalvolatility(andriskoflosses)inthecaseofthe100-stockportfoliobecausetheidiosyncraticriskofthediversifiedportfolioissosmall.17. a.,b.,c. Hedge Hedge Hedge Fund StandAlone- Fund1 Fund2 Fund3 ofFunds FundStartofyearvalue(millions) $100.0 $100.0 $100.0 $300.0 $300.0Grossportfoliorateofreturn 20% 10% 30% Endofyearvalue(beforefee) $120.0 $110.0 $130.0 $360.0Incentivefee(Individualfunds) $4.0 $2.0 $6.0 $12.0Endofyearvalue(afterfee) $116.0 $108.0 $124.0 $348.0 $348.0Incentivefee(FundofFunds) $9.6 Endofyearvalue(FundofFunds) $338.4 Rateofreturn(afterfee) 16.0% 8.0% 24.0% 12.8% 16.0%Notethattheendofyearvalue(after-fee)fortheStand-Alone(SA)FundisthesameastheendofyearvaluefortheFundofFunds(FF)beforeFFchargesitsextralayerofincentivefees.Therefore,theinvestor’srateofreturninSA(16.0%)ishigherthaninFF(12.8%)byanamountequaltotheextralayeroffees($9.6million,or3.2%)chargedbytheFundofFunds. d. Hedge Hedge Hedge Fund StandAlone- Fund1 Fund2 Fund3 ofFunds FundStartofyearvalue(millions) $100.0 $100.0 $100.0 $300.0 $300.0Grossportfoliorateofreturn 20% 10% -30% Endofyearvalue(beforefee) $120.0 $110.0 $70.0 $300.0Incentivefee(Individualfunds) $4.0 $2.0 $0.0 $0.0Endofyearvalue(afterfee) $116.0 $108.0 $70.0 $294.0 $300.0Incentivefee(FundofFunds) $0.0 Endofyearvalue(FundofFunds) $294.0 Rateofreturn(afterfee) 16.0% 8.0% -30.0% -2.0% 0.0%Now,theendofyearvalue(afterfee)forSAis$300,whiletheendofyearvalueforFFisonly$294,despitethefactthatneitherSAnorFFchargeanincentivefee.ThereasonforthedifferenceisthefactthattheFundofFundspaysanincentivefeetoeachofthecomponentportfolios.Ifevenoneoftheseportfoliosdoeswell,therewillbeanincentivefeecharged.Incontrast,SAchargesanincentivefeeonlyiftheaggregateportfoliodoeswell(atleastbetterthana0%return).Thefundoffundsstructurethereforeresultsintotalfeesatleastasgreatas(andusuallygreaterthan)thestand-alonestructure.CHAPTER27:THETHEORYOFACTIVEPORTFOLIOMANAGEMENTPROBLEMSETSViewsabouttherelativeperformanceofbondscomparedtostockscanhaveasignificantimpactonhowsecurityanalysisisconducted.Forexample,asaresultofapredicteddecreaseininterestrates,bondsarenowexpectedtoperformbetterthanpreviouslyexpected.Thisperformanceforecastmayalsoreflectforecastsaboutthequality(credit)spreadsforbonds.Inadditiontotheimplicationsofmacroforecasts,theplayonyieldscanhaveimportantimplicationsforcorporationsinfinancialdistresswithhighleverage.Thehierarchyofuseofthemodelsuggestsatop-downanalysis,startingwiththeBLmodelinputs.Thisdoesnotruleoutfeedbackintheoppositedirectionif,forexample,thepreponderanceofsecurityanalysissuggestsanunexpectedlygood(orbad)economy(oreconomicsector).Thespecifictasksfortheeconometricsunitmightentailthefollowing:Helpthemacroforecasterswiththeirforecastsforassetallocationandinsettingup‘views’fortheBLmodel.HelptheQualityControlunittoestimateforecastingrecords.Providearesourcetohandlestatisticsproblemsthatotherunitsmayencounter.Exerciselefttostudent;answerswillvary.Exerciselefttostudent;answerswillvary.Toassignadollarvaluetoanimprovementinperformance,wewouldstartwiththeexpectedvalueofM2.Thisistheexpectedincrementalreturn(riskadjusted)fromactivemanagement.ApplythisincrementalM2tothedollarvalueoftheportfoliooverfutureperiodsandcomputethepresentvalueofthesedollarincrementstodeterminethedollarvalueoftheactivity.ProceedtoobtaintheincrementalM2inatop-downmanner.EstimatetheimprovementintheSharperatiowhichcomesfromanincreaseintheinformationratio(IR)oftheactiveportfolio.Theactivityenvisionedinthisproblemamountstoanimprovementintheforecastingaccuracyofananalystwhoexaminesasetnumberofsecurities.ThislimitstheimprovementoftheoverallIRtothatofthosesecurities.(RecallthattheoverallsquaredIRisthesumofsquaredIRsoftheindividualsecurities.)Improvedaccuracymeansgreaterweightgiventotheanalyst’sforecasts.ThisconstitutesanincrementtotheexpectedIRoftheanalyst.TheexpectedIRofsecuritiescoveredbytheanalyst(thatmayarisefromeitherpositiveornegativealphaforecasts)maybeobtainedintwoways:(1)directlyfromtheanalyst’spastforecasts;or,(2)fromestimatesofthedistributionofpastabnormalreturnsofthestockinquestion. 27-1CHAPTER28:INVESTMENTPOLICYANDTHEFRAMEWORKOFTHECFAINSTITUTEPROBLEMSETSYouwouldadvisethemtoexploitallavailableretirementtaxshelters,suchas403b,401k,KeoghplansandIRAs.Sincetheywillnotbetaxedontheincomeearnedfromtheseaccountsuntiltheywithdrawthefunds,theyshouldavoidinvestingintaxpreferredinstrumentslikemunicipalbonds.Iftheyareveryrisk-averse,theyshouldconsiderinvestingalargeproportionoftheirfundsininflation-indexedCDs,whichofferarisklessrealrateofreturn.a. Theleastriskyassetforapersoninvestingforherchild’scollegetuitionisanaccountdenominatedinunitsofcollegetuition.SuchanaccountistheCollegeSureCDofferedbytheCollegeSavingsBankofPrinceton,NewJersey.AunitofthisCDpays,atmaturity,anamountguaranteedtoequalorexceedtheaveragecostofayearofundergraduatetuition,asmeasuredbyanindexpreparedbytheCollegeBoard.Theleastriskyassetforadefinedbenefitpensionfundwithbenefitobligationsthathaveanaveragedurationoftenyearsisabondportfoliowithadurationoftenyearsandapresentvalueequaltothepresentvalueofthepensionobligation.Thisisanimmunizationstrategythatprovidesafuturevalueequalto(orgreaterthan)thepensionobligation,regardlessofthedirectionofchangeininterestrates.Notethatimmunizationrequiresperiodicrebalancingofthebondportfolio.Theleastriskyassetforadefinedbenefitpensionfundthatpaysinflation-protectedbenefitsisaportfolioofimmunizedTreasuryInflation-IndexedSecuritieswithadurationequaltothedurationofthepensionobligation(i.e.,inthisscenario,adurationoftenyears).(Note:ThesesecuritiesarealsoreferredtoasTreasuryInflation-ProtectedSecurities,orTIPS.)a. GeorgeMore’sexpectedaccumulationatage65: n i PV PMT FV Fixedincome 25 3% $100,000 $1,500 ? FV=$264,067 Commonstocks 25 6% $100,000 $1,500 ? FV=$511,484Expectedretirementannuity:i PV FV PMTFixedincome 15 3% $264,067 0 ? PMT=$22,120Commonstocks 15 6% $511,484 0 ? PMT=$52,664Inordertogetafixed-incomeannuityof$30,000peryear,hisaccumulationatage65wouldhavetobe:i PMT FV PV Fixedincome 15 3% $30,000 0 ? PV=$358,138Hisannualcontributionwouldhavetobe: n i PV FV PMT Fixedincome 25 3% $100,000 -$358,138 ? PMT=$4,080Thisis$2,580moreperyearthanthe$1,500currentcontribution.a. Theanswerdependsontheassumptionsmadeabouttheinvestor’seffectiveincometaxratesfortheperiodofaccumulationandfortheperiodofwithdrawals.First,weassumethat(i)taxratesremainconstantthroughouttheentiretimehorizon;and,(ii)theinvestor’staxableincomeremainsrelativelyconstantthroughout.Consequently,theinvestor’seffectivetaxratedoesnotchange,andwefindthattheRothIRAandtheconventionalIRAprovidethesameafter-taxbenefits.Alternatively,wemightconsiderascenarioinwhichahouseholdhasalowincomeearlyintheaccumulationperiodandhigherincomelaterintheaccumulationperiodandduringthewithdrawalperiod.Iftaxratesareconstantthroughoutthetimehorizon,thentheinvestor’seffectivetaxratewouldbelowerthroughouttheaccumulationperiodthanduringthewithdrawalperiod,and,asaresult,theRothIRAwouldprovidehigherafter-taxbenefits.Thisisaconsequenceofthefactthataninvestor’sRothIRAcontributionsduringtheaccumulationperiodaretaxedatthelowerrate,whilewithdrawalsfromaconventionalIRAwouldbetaxedatthehigherrate.Similarly,theconventionalIRAprovideshigherafter-taxbenefitsintheeventthattheeffectivetaxrateishigherduringtheaccumulationperiodthanitisduringtheperiodofwithdrawals.Clearly,eachofthescenariosdescribedhererepresentsanextremelyunrealisticsimplification.Theissuebecomesmorecomplexifweconsiderthemanypossiblechanges,bothintaxlawandintheinvestor’sindividualcircumstances,thatcanhaveanimpactontheeffectivetaxrate.FortheRothIRA,contributionsaremadewithafter-taxdollars,sothetaxrateisknown(andtaxesarepaid)duringtheaccumulationperiod;thetaxrateforwithdrawalsatretirementfromaRothIRAiszero,andisthereforealsoknownwithcertainty.ContributionstoaconventionalIRAduringtheaccumulationperiodaretax-free,butthetaxrateforwithdrawalsisnotknownuntilthewithdrawalsaremadeatretirement.ThistaxrateuncertaintyforaconventionalIRAhastwosources.First,theinvestorisunabletoanticipatelegislatedchangesinfuturetaxrates.Second,eveniftaxratesweretoremainconstant,theinvestorcannotdetermineherfuturetaxbracketbecauseshecannotaccuratelyforecasthertaxableincomeatretirement.Consequently,theRothIRAprovidesprotectionagainsttax-rateuncertainty,whiletheconventionalIRAsubjectstheinvestortosubstantialtaxrateuncertainty.CFAPROBLEMSa. i.ReturnRequirement:IPSYhastheappropriatelanguage.SincethePlaniscurrentlyunder-funded,theprimaryobjectiveshouldbetomakethepensionfundfinanciallystronger.Theriskinherentinattemptingtomaximizetotalreturnswouldbeinappropriate.RiskTolerance:IPSYhastheappropriatelanguage.Becauseofthefund’sunder-fundedstatus,thePlanhaslimitedrisktolerance;shouldthefundincurasubstantialloss,paymentstobeneficiariescouldbejeopardized.TimeHorizon:IPSYhastheappropriatelanguage.Althoughgoing-concernpensionplansusuallyhavealongtimehorizon,theAcmeplanhasashortertimehorizonbecauseofthereducedretirementageandtherelativelyhighmedianageoftheworkforce.Liquidity:IPSXhastheappropriatelanguage.Becauseoftheearlyretirementfeaturestartingnextmonthandtheageoftheworkforce(whichindicatesanincreasingnumberofretireesinthenearfuture),thePlanneedsamoderatelevelofliquidityinordertofundmonthlybenefitpayments.b.Thecurrentportfolioisthemostappropriatechoiceforthepensionplan’sassetallocation.Thecurrentportfoliooffers:i. AnexpectedreturnthatexceedsthePlan’sreturnrequirement;ii.AnexpectedstandarddeviationthatonlyslightlyexceedsthePlan’starget;iii.Alevelofliquiditythatshouldbesufficientforfutureneeds.ThehigherexpectedreturnwillamelioratethePlan’sunder-fundedstatussomewhat,andthechangeinthefund’sriskprofilewillbeminimal.TheportfoliohassignificantallocationstoU.K.bonds(42percent)andlarge-capequities(13percent)inadditiontocash(5percent).Theavailabilityofthesehighlyliquidassetsshouldbesufficienttofundmonthlybenefitpaymentswhentheearlyretirementfeaturetakeseffectnextmonth,particularlyinviewofthestableincomeflowsfromtheseinvestments.TheGrahamportfoliooffers:i. AnexpectedreturnthatisslightlybelowthePlan’srequirement;ii.AnexpectedstandarddeviationthatissubstantiallybelowthePlan’starget;iii.Alevelofliquiditythatshouldbemorethansufficientforfutureneeds.GiventhePlan’sunder-fundedstatus,theportfolio’sexpectedreturnisunacceptable.TheMichaelportfoliooffers:i. AnexpectedreturnthatissubstantiallyabovethePlan’srequirement;ii.AnexpectedstandarddeviationthatfarexceedsthePlan’starget;andiii.Alevelofliquiditythatshouldbesufficientforfutureneeds.GiventhePlan’sunder-fundedstatus,theportfolio’slevelofriskisunacceptable.c. Liquidityb. Organizingthemanagementprocessitself.a. AnapproachtoassetallocationthatGSScoulduseistheonedetailedinthechapter.Itconsistsofthefollowingsteps:Specifyassetclassestobeincludedintheportfolio.Themajorclassesusuallyconsideredarethefollowing:Moneymarketinstruments(usuallycalledcash)Fixedincomesecurities(usuallycalledbonds)StocksRealestatePreciousmetalsOtherSpecifycapitalmarketexpectations.Thisstepconsistsofusingbothhistoricaldataandeconomicanalysistodetermineyourexpectationsoffutureratesofreturnovertherelevantholdingperiodontheassetstobeconsideredforinclusionintheportfolio.Derivetheefficientportfoliofrontier.Thisstepconsistsoffindingportfoliosthatachievethemaximumexpectedreturnforanygivendegreeofrisk.Findtheoptimalassetmix.Thisstepconsistsofselectingtheefficientportfoliothatbestmeetsyourriskandreturnobjectiveswhilesatisfyingtheconstraintsyouface.b. Aguardianinvestortypicallyisanindividualwhowishestopreservethepurchasingpowerofhisassets.ExtremeguardianswouldbeexclusivelyinAAAshorttermcredits.GSSshouldfirstdeterminehowlongthetimehorizonisandhowhighthereturnexpectationsare.Assumingalongtimehorizonand8-10%return(pretax)expectations,theportfoliocouldbeallocated30-40%bonds,30-40%stocks,andmodestallocationstoeachoftheotherassetgroups.a. OBJECTIVESReturnTherequiredtotalrateofreturnfortheJUendowmentfundisthesumofthespendingrateandtheexpectedlong-termincreaseineducationalcosts:Spendingrate=$126million(currentspendingneed)dividedby($2,000millioncurrentfundbalanceless$200millionlibrarypayment)=$126million/$1,800million=7percentTheexpectededucationalcostincreaseis3percent.Thesumofthetwocomponentsis10percent.Achievingthisrelativelyhighreturnwouldensurethattheendowment’srealv