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FINM6016 Applied Portfolio Construction

Assignment

General Instructions and Information

1. The assignment involves producing a portfolio construction advice for a client based on specified circumstances and objectives. The assignment is to be undertaken in groups of 3 – 4 students. All students must sign up for an assignment group at Wattle by week 4, not restricted by tutorial enrolment. Any students not in a group or small groups of 2 students (except those being approved to be 2-member groups) by end of week 4 will be randomly allocated to a group. If you have to do the assignment as an individual task, you need the lecturer’s approval to do so. All students within a group will be awarded the same assignment grade, with no adjustments.

2. Assignment Summary

Penalties and Extensions:

Late submission of the assignment without an extension are penalised at the rate of 5% of the possible marks available per working day or part thereof.  Late submission of the assignment is not accepted after 10 working days after the due date, or on or after the date specified in the course outline for the return of the assignment.

Assignment extensions are not usually considered by the lecturer except for extremely rare circumstances.

Guidelines

1. The assignment should be written as a ‘business report’ by a consultant for their client. The articles by industry practitioners and journalists provided in this course can be good guides to writing in the portfolio construction context, for instance, their writing style, word choice, “story-telling” and the way of using jargons that are easily understood by readers with common-sense knowledge of the economy and financial market, etc.

2. Two analysis methods are required. Potential methods will be discussed in the Assignment Workshops. Additional and relevant analysis methods are rewarded with additional marks. The word limit is 3,000 words, which refers to the text contained in the body and appendix (if there’s important analysis to support your recommendation in the appendix). It excludes: title or contents page, tables, and any notes to tables that describe the analysis or assumptions (must not contain any interpretative materials), figures, references. This word limit is “soft” in nature. You won’t get penalty if getting over the limit with a small margin, eg. 10%. The message is that the word limit imposed should be sufficient for the assignment. “Trimming” and “cutting” are part of the exercise that you have deliver your insights to your client within a page limit in business writing.

3. Ideally the report should be ‘stand alone’ for your client to understand the analysis and the reasoning behind your recommendation. You should aim for the examiner not need to look at the Excel file to understand your report. Note: this doesn’t mean that your examiner would not look at your Excel file. If the examiner needs to dig into the models to understand your analysis, it would mean that the analysis is either poorly set out, inadequately explained, or looks like it may be wrong.

4. Marks for ‘effectiveness of communication;’ will reflect not only the appearance of the report, but also the general ease by which the report can be read and the analysis and messages can be understood. Try to use generous font sizes, ample paragraph spacing and borders. Make sure that tables and charts are formatted well. If the examiner is left wondering about your main messages or what you have done, you will lose marks.

5. All sources should be acknowledged via referencing. Consistent Harvard referencing style is required.

THE ASSIGNMENT

Mr. and Mrs. Hall are 70 years old retired entrepreneurs. They sold their shares in the property management company JAMNI they founded decades ago to their business partners and retired last year. As part of the estate planning process, they set up a discretionary family trust, The Hall Family Trust, to pass on the majority of their wealth to their children and grandchildren. Mr. and Mrs. Hall do not withdraw from the family trust for their retirement spending, which is entirely covered by their self-managed superannuation fund. They decided the primary objective of the family trust is to create wealth in a balanced manner over long term and philanthropy of their preference. The trust is managed by a small team of one manager and two investment staff through the family office platform at a top-tier global investment bank. They approached your company Terra Consultants for an independent review of the portfolio and the management process. The table below lays out more details of The Hall Family Trust.

*The family trust became seed investor in Climate Science Corporation (CSC) five years ago with an initial investment of $3 million. CSC provides risk management solutions to agricultural and forestry businesses with their state-of-the-art satellite imaging and analysis software. CSC also provides crucial inputs in planning and policy making by local councils and government agencies in managing climate related risks. They currently generate 80% of their revenues from domestic market. Further rounds of funding are already on the table to facilitate their international expansion. The family trust’s stake in CSC was valued $25 million March 2022. Besides the seed round of capital raising, The Hall Family Trust didn’t participate any further rounds. Their stake in CSC is 8% of all shares outstanding with full voting rights without dilution. The founders of CSC collectively control 50% of all voting shares and the rest are held by a few venture capital firms: Blackbird Ventures, Sequoia Capital China, Tempe Partners and Felicity.

Your manager assigned your team to prepare the report and present your advice to the clients. Through the initial meeting, you come to understand that in the report you are supposed to answer the specific questions as below:

1. Relying on their expertise and experience, they have been over weighting in properties (currently 29% of the total portfolio). Property sector was hit hardest in the early stage of the pandemic. They realize that this might present concentrated risk in one sector and seek your advice on diversifying into other assets or asset classes. Please clearly state and explain your advice how they might improve the risk-return trade-off of their total portfolio by restructuring the property holding (eg, switch from listed properties to direct properties, and/or switch from Australian properties to international properties, etc.).

2. Inflation around the world is strikingly high right now, driven by factors that cannot be resolved over short term and is expected to continue to climb further. Major central banks around the world have clearly signaled that future inflation may stay at a higher level than the average inflation of the past 40 years for quite some time. Monetary policy is forecasted to keep tightening but the increase of target interest rate will not be as steep as in the past 12 months. Your asset allocation advice is expected to address this concern and protect the trust from unexpected sustainable high inflation in the future.

3. The rising interest rate has hit the private equity investment market particularly hard, which is observed from the valuation changes of CSC. The clients would like to seek your advice if they should remain invested in CSC for long term, divest their stake (full or partial) or participate further rounds of funding given their objectives and horizon.

4. The trust is a separately managed mandate that the investment bank charges 2% of assets under management per annum. The portfolio manager’s performance is evaluated by their internal rank of portfolio return at each quarter end and a 25% performance fee is paid to the manager if their performance is above the median performance of all managers in the cohort. The clients are concerned about the performance evaluation and compensation structure of the portfolio manager but are not very clear how it may impact their portfolio. They ask you to identify and explain the major problems of how the manager’s performance is evaluated and compensated.

5. They ask that practical issues in constructing the suggested portfolio are adequately addressed, for example, the tax consequence if selling any assets; management fees and access to assets should be considered in deciding the recommended asset classes.

They would like you to construct the recommendation in a report and explain how the characteristics of various assets classes might contribute to the portfolio return and risk considering the specified objectives and constraints. They ask that you support your recommendations with numerical analysis detailing what outcomes they might expect from the new portfolio. Two analysis methods are required, with at least one method being quantitative.

They have specified some objectives and constraints of their total portfolio as follows:

(a) Three-year outcome: they want to generate the highest value possible for their portfolio in three years time. They consider themselves medium-long term investors who are more interested in the end-result.

(b) Not losing money: they want to limit the chance of their portfolio declining in value over 3 years (i.e. generating negative returns) to no more than 20%.

(c) Relative performance – portfolio vs. comparison funds: they ask that the tracking error of their portfolio versus the comparison group is no greater than 2% p.a.. Note that the comparison portfolio is a “balanced” portfolio that is expected to generate a balanced mix of capital gain and income over long term.

(d) Portfolio constraints: In order to maintain flexibility, they ask that no more than 15% of the portfolio be invested in illiquid assets, and that at least 5% of the portfolio remains invested in cash. They dislike gearing, so no borrowing or short sales are permitted.

Mr. and Mrs. Hall have provided information to assist you via the Excel file: “FINM6016 - Assignment Data S1 2023”. This file includes: portfolio weightings of the comparison group; asset return expectations and some indicative historical return indices for the asset classes of potential interest; indicative management fees for managed funds. The template of portfolio performance is provided as a guide. You may make changes as you see appropriate and construct the forecast output table in your own way.

Guidance

Workshops

· Assignment workshops will be held through the semester until week 10.

· Workshops will be recorded. The workshop notes only provide an outline of discussions.

· Please send me email of your questions regarding the assignment. I will collect the questions and answer them at workshops. In this way, I can avoid answering the same question dozens of times.

· Please note you are expected to have reviewed all lecture, tutorial and workshop materials and listened to all recordings before you come to consultations.

Some Helpful Hints

· Tutorials provide the foundation to conduct quantitative portfolio analysis in Excel. It’s essential that you understand the concepts behind the numerical analysis of the first four tutorials to start working on your assignment. Some specific issues discussed/analyzed in tutorials are:

o Tutorial #2 – bootstrapping of future returns for a given portfolio - data-based is performed, but parametric is shown (latter is mean-variance, iid); estimation of various risk measures

o Tutorial #3 – M-V optimisation; solver; imposing expected returns on historical data by adjusting the geometric mean (more relevant for generating target returns over multiple periods)

o Tutorial #4 – choosing what data to use - measurement interval and time period

o Tutorial #5 – estimating the impact of asset allocation shifts on portfolio measures; imposing expected returns on historical data by adjusting the arithmetic mean using implied views (CAPM); parametric portfolio analysis (mean-variance, single period)

o Tutorial #6 – estimating the impact of tilting strategy on portfolio measures; calculation of 1-year and 3-year (rolling) returns using shorter interval data

· This assignment requires fairly good understanding of the topics we discuss over the semester and synthesizing the learnt theories and applications in solving a real world problem. The assessment focuses on how well you customize the portfolio serving specific objectives and constraints of investors, which demonstrates the depth of your understanding of the concepts covered in the course. The assignment is not assessed by how close your recommendation is to a “correct” set of asset allocations or how well your recommended portfolio can hit the “performance targets”. The detailed requirements are set out in the Marking Guidelines at the end of the file. As an integral part of any asset allocation decision, the implementation issues of your asset allocation advice must be analyzed and discussed in the report.

· The clients are long term investors. They require long-term strategic asset allocation advice, based on long term views of financial market and economic conditions, which forms the base of your assignment grade. Incorporating the short term variations of the market in asset allocation advice is optional and only be considered as “additional” but not essential analysis in the assignment. Students are advised to evaluate the relevant marginal benefits vs. marginal costs of doing so.

· All of the numerical objectives and constraints set out for the portfolio are based on a 3-year review window. All of the quantitative portfolio measures that feed into your asset allocation analysis and the predicted portfolio outcomes should be based on this 3-year window. Analysis based on simple yearly or quarterly returns is technically wrong.

· Investor objectives may be taken as targets, not hard constraints. Working towards the intent of the stated objectives matters more than precisely meeting any stated rules. That is, do not panic if you cannot hit the objectives exactly under your assumptions – just do the best that you can for your client.

· “Two analysis methods” could involve using two data-based approaches, or one data-based and one other approach (e.g. fundamental risk approach). You may choose any methods that are appropriate for the client’s circumstances. The methods of portfolio analysis will be discussed in week 5. In any event, you are required to perform some data-based work to demonstrate the extent to which the recommended asset allocation meets client objectives. This analysis will follow on from the tutorial exercises.

· One of the themes of this course relates to the problems that can arise when analyzing data. You are expected to show appreciation for these issues in the way you perform your analysis and present your recommendations. This means trying to highlight the shortcomings of any analysis, and address them where possible. Non-data based approaches may assist in this respect.

· The asset allocation advice should be addressing the “total portfolio” of the client. Recommending how they access the assets is optional, eg. invest through Vanguard (passive) or Fidelity (active). Do note that the data provided for assignment are largely market indices when available. If you would like your investor to invest in active products, be sure to revise the expected return or other parameter matrix at your discretion. You may recommend adding any additional asset classes/assets – whatever you believe would work best for your clients. If you use additional data other than the data provided, you need to make sure you retrieve the data from a reliable and verifiable source and relevant information is provided in an appropriate manner. (As trainee analysts, students are strongly advised NOT to use data from tradingeconomics.com or any random online resources.) You always should resort to the original publisher of statistics for your analysis, such as central banks, statistical bureaus. You are expected to provide a reasonable estimate of expected return for these additional asset classes/assets.

· You should always try to do your own research and look for the data you require for your analysis. The lecturer only provides help when it is indeed necessary, for example, junk bond yield. If you ask for help with Australian CPI data, you will be directed to a reliable data source with free access. You may find all Australian statistics at http://www.abs.org.au or financial market data at http://www.rba.org.au. Australian Prudential Regulation Authority (APRA) is the government body to regulate superannuation industry. You may find tax related resources at Australian Taxation Authority www.ato.gov.au. Other good sources of country or international data can be found at Federal Reserve of the US, OECD, IMF and World Bank, mostly free access.

· The Reserve Bank of Australia is a good start to form your own understanding of the current economic and financial market landscape. Further research may be necessary to apply some of the analysis methods, ie, two-stage approach, scenario analysis.

· Assumptions. You are given a lot of assumptions in this assignment (such as expected returns of all major asset classes). If you are not satisfied with the clients’ forecast of expected returns, you can make your own forecast given a justification is provided to your client. Whenever necessary you may need to make additional (sensible) assumptions to complete all elements of the assignment. All assumptions need to be clearly laid out for your client. If necessary you need to address how your analysis may be affected if an important assumption (or several assumptions) does not hold.

· The trust doesn’t make commitment of distributions or donations at this stage. Cash flows in the client’s portfolio can be ignored for the purpose of the assignment.

· The report should read as an integrated piece, not a collection of disparate individual work. Hence, it will help to have one person in charge of the project management and all members should meet regularly, and conduct an overall review of the report at the end – allowing ample time to sort out any issues.