Questions (Asset Allocations)

Meg and Cramer Law, a married couple aged 42 and 44, respectively, are meeting with their new investment adviser, Daniel Raye. The Laws have worked their entire careers at Whorton Solutions (WS), a multinational technology company. The Laws have two teenage children who will soon begin college.

Raye reviews the Laws’ current financial position. The Laws have an investment portfolio consisting of $800,000 in equities and $450,000 in fixed-income instruments. Raye notes that 80% of the equity portfolio consists of shares of WS. The Laws also own real estate valued at $400,000, with $225,000 in mortgage debt. Raye estimates the Laws’ pre-retirement earnings from WS have a total present value of $1,025,000. He estimates the Laws’ future expected consumption expenditures have a total present value of $750,000.

The Laws express a very strong desire to fund their children’s college education expenses, which have an estimated present value of $275,000. The Laws also plan to fund an endowment at their alma mater in 20 years, which has an estimated present value of $500,000. The Laws tell Raye they want a high probability of success funding the endowment. Raye uses this information to prepare an economic balance sheet for the Laws.

In reviewing a financial plan written by the Laws’ previous adviser, Raye notices the following asset class specifications.

Equity:	US equities
Debt:	Global investment-grade corporate bonds and real estate
Derivatives:	Primarily large-capitalization foreign equities

The previous adviser’s report notes the asset class returns on equity and derivatives are highly correlated. The report also notes the asset class returns on debt have a low correlation with equity and derivative returns.

Raye is concerned that the asset allocation approach followed by the Laws’ previous financial adviser resulted in an overlap in risk factors among asset classes for the portfolio. Raye plans to address this by examining the portfolio’s sensitivity to various risk factors, such as inflation, liquidity, and volatility, to determine the desired exposure to each factor.

Raye concludes that a portfolio of 75% global equities and 25% bonds reflects an appropriate balance of expected return and risk for the Laws with respect to a 20-year time horizon for most moderately important goals. Raye recommends the Laws follow a goals-based approach to asset allocation and offers three possible portfolios for the Laws to consider. Selected data on the three portfolios are presented in Exhibit 1.

Exhibit 1:

Proposed Portfolio Allocations for the Law Family

	Cash	Fixed Income	Global Equities	Diversifying Strategies*
Portfolio 1	35%	55%	10%	0%
Portfolio 2	10%	15%	65%	10%
Portfolio 3	10%	30%	40%	20%

* Diversifying strategies consists of hedge funds

Raye uses a cost–benefit approach to rebalancing and recommends that global equities have a wider rebalancing range than the other asset classes.

ChatGPT (Incorrect - missed out children edu & endowment funding)

https://chat.openai.com/c/22ccb223-005c-47c8-8d2d-151cc156971e

Q.

Using the economic balance sheet approach, the Laws’ economic net worth is closest to:

1. $925,000.

2. $1,425,000.

3. $1,675,000.

Solution

A is correct. The Laws’ economic net worth is closest to $925,000. An economic balance sheet includes conventional financial assets and liabilities, as well as extended portfolio assets and liabilities that are relevant in making asset allocation decisions. The economic balance sheet for the Law family is shown in the following exhibit.

Assets		Liabilities and Economic Net Worth
Financial Assets		Financial Liabilities
Fixed income	450,000		Mortgage debt	225,000
Real estate	400,000
Equity	800,000
Extended Assets		Extended Liabilities
Human capital	1,025,000		Children’s education	275,000
			Endowment funding	500,000
			Present value of consumption	750,000
Total Economic Assets	2,675,000		Total Economic Liabilities	1,750,000
			Economic Net Worth	925,000

Economic net worth is equal to total economic assets minus total economic liabilities ($2,675,000 – $1,750,000 = $925,000).

Topic - THE ECONOMIC BALANCE SHEET AND ASSET ALLOCATION

Q.

Using an economic balance sheet, which of the Laws’ current financial assets is most concerning from an asset allocation perspective?

1. Equities

2. Real estate

3. Fixed income

Solution

A is correct. The Laws’ equity portfolio is heavily concentrated in WS stock (80% of the equity portfolio), and both Laws work at WS. Should WS encounter difficult economic circumstances, the investment value of WS stock and the Laws’ human capital are both likely to be adversely affected. Thus, their investment in WS should be reviewed and their equity portfolio diversified further.

ChatGPT (Totally Correct)

https://chat.openai.com/c/f463d989-f84e-4ccb-b439-84da23d2e299

The most concerning financial asset from an asset allocation perspective, given the details provided, is A. Equities.

Here's the reasoning:

• The Laws' investment portfolio is heavily concentrated in equities ($800,000), with 80% of this equity portfolio consisting of shares in Whorton Solutions (WS), their employer. This concentration creates a significant risk due to the lack of diversification, as both their employment income and a large portion of their investment portfolio are tied to the fortunes of a single company. In the event of a downturn in WS's business, the Laws could face simultaneous losses in both their investment value and employment income.

• Real estate, valued at $400,000 with a $225,000 mortgage, does not present the same level of concern regarding asset allocation. The real estate provides a tangible asset that serves as a place of residence, and while it does carry risk (market value fluctuations, maintenance costs, etc.), it does not exhibit the same high concentration risk tied to a single company's performance as the equities do.

• Fixed income investments totaling $450,000 in global investment-grade corporate bonds and real estate debt offer diversification benefits and a lower correlation with equity and derivative returns, which helps to mitigate portfolio volatility. Therefore, they are less concerning from an asset allocation perspective compared to the highly concentrated equity position.

Given the substantial concentration of their equities in one stock, the equities portion of the Laws' portfolio is the most concerning from an asset allocation perspective, as it exposes them to high company-specific and sector-specific risks.

Q.

Raye believes the previous adviser’s specification for debt is incorrect given that, for purposes of asset allocation, asset classes should be:

1. A.diversifying.
2. B.mutually exclusive.
3. C.relatively homogeneous.

Solution

C is correct. In order to effectively specify asset classes for the purpose of asset allocation, assets within an asset class should be relatively homogeneous and have similar attributes. The previous adviser’s specification of the debt asset class includes global investment-grade corporate bonds and real estate. This definition results in a non-homogeneous asset class.

ChatGPT (Correct and better)

https://chat.openai.com/c/8f62a97c-d1c1-4d07-a0d7-109f5e25b46a

"The previous adviser’s report notes the asset class returns on equity and derivatives are highly correlated. The report also notes the asset class returns on debt have a low correlation with equity and derivative returns."

This portion highlights the issue with the previous adviser's asset class specifications for equity and derivatives. It points out that the returns for these asset classes are highly correlated, which is problematic for achieving diversification within the portfolio. The goal of asset allocation is to spread risk across various asset classes that behave differently under the same economic conditions, thereby reducing the portfolio's overall risk. The high correlation between equity and derivatives contradicts this goal, as it does not provide the diversification benefit that is crucial for effective risk management in asset allocation.

Q. Raye believes the previous adviser’s asset class specifications for equity and derivatives are inappropriate given that, for purposes of asset allocation, asset classes should be: A.diversifying.

B.mutually exclusive.

C.relatively homogeneous.

Solution

A is correct. For risk control purposes, an asset class should be diversifying and should not have extremely high expected correlations with other classes. Because the returns to the equity and the derivatives asset classes are noted as being highly correlated, inclusion of both asset classes will result in duplication of risk exposures. Including both asset classes is not diversifying to the asset allocation.

ChatGPT (Incorrect)

https://chat.openai.com/c/a89e611e-9683-424b-824a-01e3ef7fb8ed

My thoughts and understanding:

The relevant text is

"The previous adviser’s report notes the asset class returns on equity and derivatives are highly correlated. The report also notes the asset class returns on debt have a low correlation with equity and derivative returns."

so one the first question

report said - debt has low corr

and question

input: Raye disagree (mean debt should have high corr as well)

why: coz asset should be relatively homogenenous (meaning debt should have similar corr)

On the 2nd question

report said - equity and derivatives are highly corr

question

input: Raye disagree (mean he think they're having low corr)

why: coz asset should be diversifying

Q.

To address his concern regarding the previous adviser’s asset allocation approach, Raye should assess the Laws’ portfolio using:

1. A.a homogeneous and mutually exclusive asset class–based risk analysis.
2. B.a multifactor risk model to control systematic risk factors in asset allocation.
3. C.an asset class–based asset allocation approach to construct a diversified portfolio.

Solution

B is correct. Raye believes the Laws’ previous financial adviser followed an asset allocation approach that resulted in an overlap in risk factors among asset classes. A multifactor risk model approach can be used to address potential risk factor overlaps. Risk factor approaches to asset allocation focus on assigning investments to the investor’s desired exposures to specified risk factors. These methods are premised on the observation that asset classes often exhibit some overlaps in sources of risk.

ChatGPT (Correct)

https://chat.openai.com/c/9b496f35-ba7a-4b92-9922-e4357b91c32c

Q.

Based on Exhibit 1, which portfolio best meets the Laws’ education goal for their children?

1. A.Portfolio 1
2. B.Portfolio 2
3. C.Portfolio 3

Solution

A is correct. Portfolio 1 best meets the Laws’ education goal for their children. The estimated present value of the Laws’ expected education expense is $275,000. Given that the children will be starting college soon, and the Laws have a very strong desire to achieve this goal, Portfolio 1, which stresses liquidity and stability, is most appropriate to meet the Laws’ short-term education goal.

ChatPT (wrong)

https://chat.openai.com/c/da7afaa6-e61b-4e7b-8bc3-b0af61e0690a

Q.

Based on Exhibit 1, which portfolio best meets the Laws’ goal to fund an endowment for their alma mater?

1. Portfolio 1

2. Portfolio 2

3. Portfolio 3

Solution

B is correct. Portfolio 2 best meets the Laws’ goal to fund an endowment for their alma mater in 20 years. In present value terms, the gift is valued at $500,000, with the Laws desiring a high probability of achieving this goal. Although slightly more conservative than the 75/25 global equity/bond mix, Portfolio 2 has a greater growth emphasis compared with Portfolios 1 and 3. Therefore, Portfolio 2 is best for funding the endowment at their alma mater given the goal’s long-term horizon and the Laws’ desire for a high probability of achieving it.

ChatGPT (Correct)

https://chat.openai.com/c/bac0d437-95e0-4ff2-9cde-b5f4bd47096e

To determine which portfolio best meets the Laws’ goal to fund an endowment for their alma mater, we need to consider the Laws' preference for a high probability of success in funding the endowment in 20 years. This goal suggests a need for a portfolio that balances growth potential with risk management, given the relatively long time horizon.

The Laws' desire for a high probability of success in funding a significant future financial goal implies the need for a portfolio with a substantial allocation to growth-oriented assets, such as equities, while still maintaining some level of risk control. Let's review the characteristics of the three proposed portfolios:

• Portfolio 1 is conservative, with 35% in cash and 55% in fixed income, leaving only 10% for global equities. This portfolio prioritizes safety and income but has limited growth potential, which may not align well with the goal of funding a substantial endowment in 20 years.

• Portfolio 2 is aggressive, with a 65% allocation to global equities and 10% in diversifying strategies (hedge funds), alongside a smaller allocation to cash (10%) and fixed income (15%). This portfolio offers a high growth potential, which is crucial for meeting long-term goals like funding an endowment, albeit with higher volatility and risk.

• Portfolio 3 offers a balanced approach, with 40% in global equities and 20% in diversifying strategies, complemented by a significant allocation to fixed income (30%) and cash (10%). This portfolio aims to provide a moderate growth potential with a degree of risk management through diversification.

Given the Laws' goal of funding an endowment in 20 years, which suggests a need for a portfolio that can provide substantial growth over the long term while managing risk, Portfolio 2 appears to be the most suitable option. It has the highest allocation to global equities, which are expected to offer the best growth potential over a 20-year horizon, essential for accumulating the necessary funds for the endowment. The inclusion of diversifying strategies (10%) adds an element of risk management while potentially enhancing returns, aligning with the Laws' desire for a high probability of success in meeting their goal.

Therefore, the answer is B. Portfolio 2.

Q.

Raye’s approach to rebalancing global equities is consistent with:

1. the Laws’ being risk averse.

2. global equities’ having higher transaction costs than other asset classes.

3. global equities’ having lower correlations with other asset classes.

Solution

B is correct. Using the cost–benefit approach, higher transaction costs for an asset class imply wider rebalancing ranges. Raye’s recommendation for a wider rebalancing range for global equities is consistent with the presence of higher transaction costs for global equities.

ChatGPT (Correct and accurate)

Raye's approach to rebalancing, which suggests that global equities should have a wider rebalancing range than other asset classes, reflects an understanding of the characteristics and behavior of different types of investments within a portfolio. Here's how this approach aligns with each of the given options:

A. The Laws’ being risk averse: This option does not directly relate to the rationale behind having a wider rebalancing range for global equities. Risk aversion is a characteristic of investors' preferences, influencing their overall portfolio construction rather than specific rebalancing strategies for individual asset classes.

B. Global equities’ having higher transaction costs than other asset classes: A wider rebalancing range for global equities could indeed be justified by higher transaction costs associated with trading in these markets. By allowing a broader range before triggering rebalancing, it minimizes the need for frequent trades, thus reducing the impact of transaction costs on the portfolio’s overall performance. However, while this is a plausible reason, it is not explicitly stated in the given context.

C. Global equities’ having lower correlations with other asset classes: Having a lower correlation with other asset classes can be a valid reason for a wider rebalancing range because it implies that global equities might behave differently from other investments in the portfolio. This difference in behavior can provide diversification benefits, and a wider rebalancing range could allow investors to capture more of these benefits before rebalancing. However, the rationale here is more about capturing the diversification benefits rather than the specific mechanics of rebalancing ranges.

The question seems to focus on the rationale behind setting different rebalancing ranges for global equities compared to other asset classes. Given the information provided:

• Option A is not directly relevant to the specifics of rebalancing strategies based on asset characteristics.

• Option B is plausible and directly relates to the operational aspect of managing a portfolio, where minimizing costs is a key consideration.

• Option C also makes sense in a portfolio context, as diversification and correlation are critical factors in determining rebalancing triggers and ranges.

The most direct justification for Raye’s approach, based on the information provided, seems to be B: global equities’ having higher transaction costs than other asset classes, as it directly relates to the operational efficiency and cost-effectiveness of rebalancing strategies. However, without explicit mention of transaction costs or correlations in the context given, B is the option that most logically connects to the practice of setting wider rebalancing ranges to manage costs effectively.