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Sophia Doulton, CFA, owns Doulton Investments, LLC, an asset management firm. She is preparing for a meeting with Jorge Thompson, a new client. At an earlier meeting, Thompson provided information about his current portfolio holdings and the investment policy statement (IPS) created for him by his previous investment adviser. Thompson has stated that he is generally happy with the IPS but left the previous adviser because of high fees and poor investment returns. He asked Doulton to review the IPS and let him know if changes are warranted.Thompson's current IPS includes the strategic asset allocation shown in Exhibit 1. Doulton's long-term and short-term return expectations for each asset class are included. The IPS allows for asset allocations that diverge from its strategic allocations based on the following rules and reasoning:Rule 1: The portfolio should always overweight emerging market equities because most long-term forecasts show high expected returns for this asset class relative to the others.Rule 2: The asset manager may make tactical allocations to asset classes not included in the strategic asset allocation because the portfolio manager has discretion to pursue excess returns wherever they are available.Rule 3: The total allocation to bonds (U.S. and non-U.S.) should never be less than 35% because Thompson views the bond allocation as being his retirement portfolio and does not want too much risk taken with that money.Doulton is considering two additional asset classes that could be added to Thompson's strategic asset allocation. Information about the current portfolio and these two asset classes is found in Exhibit 2. Thompson's previous investment adviser used a single-period mean-variance approach to determine his optimal strategic asset allocation. Doulton is concerned about this because most of the portfolio's returns are taxable and are subject to a variety of marginal rates, depending on the type and length of the investment. Furthermore, Thompson's income over the next 10 years will likely result in substantial additional contributions to the portfolio. Doulton plans to recommend a different approach to optimization for Thompson.Thompson does not currently hedge any of the currency risk in his strategic portfolio, which contains a 40% foreign asset exposure. He asks Doulton to estimate the impact of currency risk on that part of his portfolio. Doulton estimates the standard deviation of Thompson's foreign assets in local currency terms to be 22%, the standard deviation of the exchange rate is 12%, and the correlation between foreign asset returns in local currency and exchange rate movements is 0.4. |
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