Capital Market Assumptions given in Appendix

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Capital Market Assumptions given in Appendix

ASSIGNMENT

Word limit: 2000

This assignment has two parts, Part 1, 36 points and Part 2, 15 points.

PART 1 (36 points) Task overview

In Part 1, students will build a strategic asset allocation consistent with their risk profile. Each student will be assigned a risk profile.

Find your assigned level of risk tolerance from the following table: Your risk tolerance is assigned based on your first name.

Risk Tolerance Level
Very low

Students are required to use this risk profile and select assets from the Capital Market Assumptions given in

Appendix 1 to create your strategic asset allocation.

Detailed questions

  1. You have been assigned an investor profile that describes your risk tolerance. You must answer the following questions based on the risk tolerance level assigned to you. Your financial goal is to save for retirement. Risk tolerance is defined in terms of the maximum loss (maximum drawdown) of your portfolio you are comfortable with, as shown in Table

Table 1: Risk tolerance

Risk Tolerance Maximum acceptable loss
Very low 10%
Low 15%
Moderate 20%
High 30%
Very high 40%
  1. From the following reference portfolios in Table 2 and the information provided in Table 3, choose the one that fits your assigned risk profile. To calculate the maximum drawdown of a reference portfolio, use this rule of thumb: Maximum drawdown = 3xVolatility. Please mention your risk tolerance level when you answer this (4 points)

Table 2: Reference portfolios

  Global Equity Global Bond Hedged*
Portfolio 1 100% 0%
Portfolio 2 70% 30%
Portfolio 3 45% 55%
Portfolio 4 20% 80%
Portfolio 5 5% 95%

*Hedged means hedged in Australian dollars.

Table 3: Capital Market Assumptions (Expected 10-year annualised)

      Correlation Coefficient
  Expected Return Expected Volatility Global Equity Global Bond hedged
Global Equity 7.20 13.37 1 0.11
Global Bond Hedged 4.56 3.50 0.11 1
  1.  Explain why you selected this reference portfolio (i.e., how the chosen reference portfolio is consistent with your risk profile and others are not). (4 points)
  2. What is your reference portfolio’s expected rate of return and volatility? (show calculation) (3 points)
  3. Now, you must find your strategic asset allocation (construct the policy portfolio). Use the capital market assumptions given in Appendix 1 for your strategic asset allocation. Use Carver’s Top-down
  4. Prepare a table like the one below with asset classes on the column and the weight of each asset class in rows to show your final constructed portfolio. (The table 4 is an example. Add/delete rows according to the assets you choose.). Your portfolio must satisfy the following conditions:
  5. You must include at least six asset classes (other than cash) in your
  6. You cannot have more than 5% of your portfolio allocated to
  • If you decide to include alternative asset classes in your portfolio, divide Global Equity allocation between Equities and
  1. Your allocation to Alternatives cannot exceed 10% of your (7 points)

Table 4: Strategic Asset Allocation

(This is only an example. Add/delete rows according to the assets you choose)

  Reference portfolio Cash Weight Reference portfolio Cash Weight Strategic Asset Allocation Cash Weight
 

 

 

 

 

 

Asset class

 

 

 

Global Equity

   

Equity

  AU Equity  
DM ex-AU Equity  
EM Equity  
 

Alternatives

 

≤10%

Private Equity  
Core Real Estate  
 

Global Bond Hedged

   

Global Bond Hedged

  AU Govt Bonds  
AU Inflation-linked Bonds  
Cash ≤5%
  1. Please mention why you chose these asset classes in your portfolio. For example, if you have selected only AU Equity and DM ex-AU Equity in your portfolio, explain why you selected these two of the six asset classes under Equities. (5 points)
  2. Suppose you are 45 years old. Would you change your reference portfolio and strategic asset allocation if you were 20 years younger? If yes, how? If not, why? (3 points)
  3. Suppose you are 45 years old. Would you change your reference portfolio and strategic asset allocation if you were 20 years older? If yes, how? If not, why? (3 points)
  4. Carver’s Top-down approach used only the volatility information in constructing the strategic asset allocation. However, expected returns are also important for building a
  5. From the capital market assumptions in Appendix 1, estimate the risk-adjusted return (Sharpe Ratio) of each asset class in your strategic asset allocation. (2 points)
  6. Based on the risk-adjusted returns, are there any obvious asset classes that you would want to overweight or underweight (in other words, tilt the weights) any of these assets in your portfolio? (If an asset has a weight of 8% in your strategic asset allocation, and you decide to increase the weight to 10%, that will be an example of overweighting that asset class). Show your tilted weights in a table (Use Table 5 as an example). (2 points)
  7. Explain why you have tilted (or have not tilted) the weights from your strategic asset         (3 points)

Table 5: Strategic Asset Allocation

(This is only an example. Add/delete rows according to the assets you choose)

  Reference portfolio Cash Weight Reference portfolio Cash Weight Strategic Asset Allocation Cash Weight Risk- Adjusted Return Tilted Weight
 

 

 

 

 

 

Asset class

 

 

 

Global Equity

   

Equity

  AU Equity      
DM ex-AU Equity      
EM Equity      
 

Alternatives

 

≤10%

Private Equity      
Core Real Estate      
 

Global Bond Hedged

   

Global Bond Hedged

  AU Govt Bonds      
AU Inflation-linked Bonds      
Cash ≤5%    

PART 2 (15 points)

In Part 2, students will assume the role of a financial advisor in a Super Fund and recommend investment options to a client assigned to you. The age of your client and their risk tolerance are based on the following table:

Age of your client and their risk tolerance
28, Moderate

Risk Tolerance Maximum acceptable loss
Very low 10%
Low 15%
Moderate 20%
High 30%
Very high 40%

Background

Suppose you are a financial advisor at UniSuper. You have a PhD in finance, specialising in investments, and are familiar with all the complexities of advanced investment strategies. Through twenty years of practical experience working with clients, however, you have concluded that simple heuristics work best most of the time.

One such heuristic you rely upon is the client’s age as the starting point for the percentage invested in fixed interest, cash and credit as the basis for choosing an investment option for a client saving for retirement. So, a 25-year-old client would be advised to invest in an option with at least 25% in fixed interest, cash and credit.

You then adjust this percentage upward to Age minus ten if the client is more tolerant of risk and increase it by ten per cent if the client is less tolerant.

Additionally, you believe the minimum allocation to fixed interest, cash and credit should be at least 20 per cent and a maximum of 80 per cent.

Problem

You have been assigned a client with a specific level of risk tolerance and age. Use this document by UniSuper to answer the following questions.

  1. Which of the UniSuper pre-mixed options would you recommend? Why? (2+5 points)
  2. What would be the expected return in excess of CPI for this option, based on UniSuper projections? (3 points)
  3. Your client has reviewed the recommendation and requested you recommend a strategy with exposure to sustainable investing. Given your heuristic-based process for recommending options, is one of the pre-mixed sustainable investing options suitable? If not, what should you recommend? Explain your answer. (5 points)

Appendix 1: Capital Market Assumptions (10-year Annualised)

  Asset Class Nominal Expected Returns

(%)

Expected Volatility (%)
  Cash 2.90 0.71
  AU Credit 4.84 2.82
  AU Govt Bonds 4.39 4.27
FIXED INCOME AU Inflation-Linked Bonds 4.70 6.45
  AU Aggregate Bonds 4.60 5.10
  World ex-AU Bonds hedged 4.37 3.48
  AU Equity 9.71 14.22
  U.S. Equity 5.10 13.11
  DM ex-US Equity 8.42 11.37
EQUITIES EM Equity 8.35 15.10
  DM Equity 8.10 12.50
  DM ex-AU Equity 7.00 12.37
  DM ex-US ex-AU Equity 8.04 11.20
  Core Real Estate 6.99 12.20
  Infrastructure 8.80 16.90
ALTERNATIVES Gold 4.17 16.40
  Private Equity 9.57 15.42
  Diversified Hedge Funds 7.20 6.20

 Note: AU = Australian. DM= Developed Markets, EM = Emerging Markets, hedged means hedged in Australian dollars

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