Question

You are the Chief Investment Officer of a large Australian investment fund which is currently invested in a broadly diversified portfolio of Australian bonds (40 per cent) and Australian shares (60 per cent). You believe that further diversification through the addition of other asset classes would both reduce portfolio risk and increase portfolio return.

Analysis presented to you shows that depressed conditions in Australian real estate markets are offering opportunities for property acquisitions at levels of expected return that are unusually high by historical standards. It has been suggested that the fund rebalance the portfolio so that it’s asset allocation is 20 per cent real estate, 30 per cent bonds and 50 per cent shares.

The following information has been presented to you to support this recommendation:

_______Correlation Matrix___________­­­

Standard Aust. Aust. Aust.          Aust.

Asset Class Return Deviation   Stocks Bonds Real Est.    T-Bills

Aust. Shares 12.0% 21.0% 1.00      

Aust. Bonds 8.0 10.5 0.14 1.00  

Aust. Real Estate 12.0 9.0 - 0.04       -0.03 1.00

Aust. T-Bills 4.0 0.0          -0.05 -0.03 0.25 1.00        

Required:

(a)        explain the effect on both portfolio risk and return that would result from the addition of Australian real estate and the suggested fund rebalancing. Your explanation should identify two reasons for any expected change in portfolio risk.   

(b)        Having studied finance theory, you question the accuracy of the information you have been given about return and standard deviation for Australian real estate. Explain why you would question this information.   

Answer 1

The data given in the question can be written in tabular form as given below:

As per Current investment portfolio:

Expected Return = E(R_p) = (12% * 60%) + (8% * 40%) = 10.4%

    

As per Proposed investment portfolio:

Expected Return = E(R_p) = (12% * 50%) + (8% * 30%) + (12% * 20%)= 10.8%

    

So we can see that the proposed investment portfolio with addition of Aust. Real Estate will give

a) More Return than current portfolio

b) Low risk than current protfolio

The proposed investment portfolio with addition of Aust. Real Estate has lower risk because

a) The correlation between Aust. Stock and Aust. Real Estate is negative. Hence the mixing of these two assets in the protfolio reduces the overall risk.

a) The correlation between Aust. bond and Aust. Real Estate is negative. Hence the mixing of these two assets in the protfolio reduces the overall risk.

b) The information given can be questioned because:

1) There is no information about the Systematic Risk (market related risk) which cannot be eliminated through diversification

2) Information about Sensitivity coefficient (Beta) has not been given. Beta helps in assessing market/systematic risk.

3) % of error in the given data is not given.