Efficient Portfolios

Question 1

What is the efficient frontier?

Answer 1

All possible portfolios with different weightings in the assets are plotted on a graph with expected returns (y axis) mesured against standard deviation (x axis).

These portfolios will have a maximum return for any level of risk and therefore will lie on or below a curve known as the efficient frontier.

This is the set of portfolios that can provide the max level of return for a given level of risk.

If we can identify the right level of risk for a client, then the portfolio that offers the best/risk reward trade off will be the one lying on the efficient frontier with this level of risk assuming the input data is correct.

Question 2

Find the most efficient portfolio?

Answer 2

Minmum variance will be around 80% asset A and 20% asset B.

Most efficient is around 70% asset A and 30% asset B.

The most efficent portfolio is not the minimum risk portfolio.

Question 3

Should the investor use money market or treasury bills?

Answer 3

Money market has zero systematic risk and the zero beta CAPM which better reflects actual practice and empirically predicts better.

Treasury bill can be used as the Treasury bill has zero systemic and unsystematic risk - its default free, and this is an important factor even though it may sometimes not be risk free in real, inflation adjusted terms.

Question 4

Why might an individual not choose the efficient portfolio?

Answer 4

• Additional rate taxpayer may prefer returns as capital gain rather than income.
• May want to tilt her portfolio toward growth style assets, which would be less than fully diversified.
• May want to choose VCTs, EIS, SEIS were less tax is paid thought there is additional risk and this may not be suitable in Amanda’s case.

Question 5

When should an investor add a new asset class to their portfolio?

Answer 5

The investor should only accept a new asset if its sharpe ratio is greater than the portfolios sharpe ration x by correlation coefficent.

asset sharpe ratio > portfolio sharpe ratio x correlation

Investors should accept the overseas government bonds as its Sharpe ratio – 0.35 – is larger than portfolios Sharpe ratio x correlation

or

The investor should accept a new asset class if its Sharpe ratio divided by correlation coefficient is greater than the portfolio’s Sharpe ratio.

Again, we accept the government bond as the ratio of 0.58 is larger than portfolio Sharpe ratio.

Question 6

What are the drawbacks of the efficent portfolio theory?

Answer 6

• Model will only be succesfful if the inputs are accurate, so if forecast returns are not met, the portfolios identified by the model are unlikely to be optimal.
• If historic data is used for risk and correlation it is unlikely to be a perfect indicator of futre risk and correlation.
• In a crisis, correlations are highly unstable and correlations between equities tend to move towards 1. This reduces the benefit of diversification just when it may be needed most.
• STDEV is assumed appropriate as a risk measure, others such as liquidty risk are not incorporated into the model.
• The model does not incorporate transactins costs and may lead to a high level of turniver than a client is comfortable with.