Question

George Stephenson’s current portfolio of \(2 million is invested as follows:

	Summary of Stephenson's current portfolio
	Value	Percent of total	Expected annual return	Annual Standard Deviation
Short term bonds	\) 200000	10%	4.60%	1.60%
Domestic large cap equities	\( 600000	30%	12.40%	19.50%
Domestic small cap equities	\) 1200000	60%	16%	29.90%
Total portfolio	\( 2000000	100%	13.80%	23.10%

Stephenson soon expects to receive an additional \)2 million and plans to invest the entire amount in an index fund that best complements the current portfolio. Stephanie Coppa, CFA, is evaluating the four index funds shown in the following table for their ability to produce a portfolio that will meet two criteria relative to the current portfolio: (1) maintain or enhance expected return and (2) maintain or reduce volatility.

Each fund is invested in an asset class that is not substantially represented in the current portfolio.

Index Fund Characteristics

Index Fund	Expected Annual Return	Expected Annual Standard Deviation	Correlations of returns with current portfolio
Fund A	15	25	0.80
Fund B	11	22	0.60
Fund C	16	25	0.90
Fund D	14	22	0.65

State which fund Coppa should recommend to Stephenson. Justify your choice by describing how your chosen fund best meets both of Stephenson’s criteria. No calculations are required.

Short answer

Fund D

Step-by-step solution

Evaluation of recommendations of Fund D to Stevenson

Fund D

Justification:

(a) It’s expected return of 14.0 percent can potentially increase its return.

(b) It’s low correlation with current portfolio of (+0.65) can potentially provide greater diversification benefits.

Evaluation of non-recommendations of Fund A, B and C

Justification: Why no fund A, B, or C?

(a) They have shortcomings in their expected return enhancement or volatility reduction through diversification benefits.

(b) Though Fund A and C provide the potential to bring in an increase in the portfolio’s return, due to their high correlation, these won’t be able to provide substantial volatility reduction benefits through diversification.

(c) On the other hand, Fund B provides volatility reduction, but it generates a return below the current portfolio’s return