Mutual Fund Policy statement

By

G.M.ARIF

Submitted in fulfillment of the requirements for the degree of

MSc Risk Management and Financial Engineering

In the Subject of

Modern Portfolio Management

At the

th
15 of April 2010
 Contents
1. Statement of Investment objectives and policies…………………………….1
1.1 Investment objective statement………………………………………………...2
1.2 Investment strategy…………………………………………………………….3
1.3 Investor’s profile……………………………………………………………….4
1.4 Risk and return profile………………………………………………………….5
1.5 Investment constraints………………………………………………………….6
2. Asset allocation………………………………………………………………..7
2.1 Asset class ……………………………………………………………………..8
2.2 Economic and global view……………………………………………………10
2.3 Why investing in MSCI Index………………………………………………….9
2.4 Equity selection……………………………………………………………….11
2.5 Bond Selection………………………………………………………………..14
1. Why EFFAS diversified bond index………………………………………18
2. Some economic aspects of investment in bonds…………………………..17
2. Canadian Government bond…………….………………….………………15
3. Newzeland government bond…….………………………………………...16
4. Euro zone bond…………….…..……………….………………………….17

3. Data Analysis

4. Portfolio construction…………………………………………………………19
5. The efficient frontier…………………………………………………………..20
6. Computing return……………………………………………………………..22
7. Benchmarking…………………………………………………………………23
8. Decision on Investment……………………………………………………….25
9. Reference…………………………………………………………….………..26
10. Bibliography………………………………………………………….……….27

Appendix 1 , 2, 3, 4, 5, 6, 7, 8, 9, 10 and 11.

 List of Charts
1. MSCI Bara Equity index.
2. Material sector market price performance.
3. Metal and Mining market price
4. Textile sectors market price
5. Utilities Market price performance
6. Pharmaceuticals sectors price performance
7. Portfolio equity sectors performance
8. Portfolio Bond sectors performance
9. Percentage of total return of the Portfolio
10. Individual asset risk of the portfolio
11. Sector’s performance of the portfolio
12. Efficient Frontier of the portfolio
13. Equity Performance on Portfolio
14. Debts ( Fixed income security) instruments performance on portfolio
15. Equally weighted portfolio
16. Initial sectors performance movement
17. MSCI global index’s equity sectors performance
18. EFFAS Bond index
19. Graph price of Australian bond of EFFAS
20. Australian bond composite quote
21. Australian economy
22. NZ economy forecast
23. NZ graph price of EFFAS
24. Euro zone Bond graph price
 List of models:
1. The mean of a portfolio along with the Optimal CAL.
2. The Portfolio Performance measurement as follows.
3. Treynor Portfolio performance measure.
4. Jensen portfolio Measure
5. Information ratio calculation.
6. Sharp ratio measurement.
7. Rate of Inflation
8. Calculation of Expected return on Portfolio
9. Formula for standard deviation of “n” Number of securities
10. Formula for minimum variance of a portfolio
11. The Standard deviation of each stock.
12. The correlation coefficient between securities
13. The Optimal risky portfolio
14. The adjustment for the Beta.
15. The Index’s tracking error.
16. Actual tracking error.
17. Sharp ratio for the combined portfolio
18. A mutual fund SML model.
19. The model of Historical risk of an asset.
20. Standard deviation
21. Covariance calculation formula
22. Correlation calculation formula
23. Portfolio standard deviation formula
24. The Model for the Future Bond price calculation
25. Percentage of the Change in Bond price calculation
26. The Model for the Bond Price volatility
27. Variance
28. Determinants of Convexity
29. The model for the variance of returns for a risky asset
30. The Bond holding period model.
31. The formula for the risk measure for the CML
32. Tracking error.
1. STATEMENT OF I NVESTMENT OBJECTIVES AND POLICIES

Shavron portfolio fund investment is a professional structured mutual fund which

involves diversified securities and fixed income investments. Strategically spread
among two assets classes, namely equities and bond particularly government bond
which also known as fixed income debt instruments. It is a mutual fund based in New
York, US and the portfolio is denominated in US Dollar ($). It is a passively managed
portfolio with a short term horizon. A top-down approach is used for the portfolio
construction.

1.1 Investment objective statement

Shavron Mutual fund is designed to achieve a balance between capital growth and
income over a short duration framework. It also designed to concentrate on the
medium risk tolerated investors.

1.2 Investment strategy

In this Mutual fund we aim to create a balance between capital income and growth by
diversified investments into most popular MSCI index for equity and the EFFAS
bond index for the fixed income debt securities that measures the performance of the
world’s most prominent companies including, different investment banks and fund
management companies United States. Furthermore, in this mutual fund we diversify
investments by exploring the different best performed sectors in the MSCI index and
higher returned and low duration bonds. Then we allocate the assets into different
weights which are equally weighted. Afterwards, we benchmark the portfolio
performance to measure the best performance out of this portfolio.

1.3 Investor’s profile

The investor’s class we are catering to, belongs to the above 45 years age group. The
investors are nearing the retirement and the spending phase of their life-cycle. (Figure
given below)

Investor characteristics: Moderately aggressive

Investor goals: Growth, income and capital gains thereby seeking balance between
current income and total returns.
 Figure: 1 rise and fall of personal net worth over a lifetime

Source: Reilly&Brown, Chapter 2.

Investor’s needs: Since the investors are in the spending phase of their life, he/she is nearing
retirement. They need a cushion against their accumulated capital at the same time they need
liquidity to fulfill their desires of a decently high standard of living.

Investor risk tolerance: Moderate risk

1.4 Risk and return profile

Considering the investor profile and their needs and preferences, we intend to make a
risk-medium return portfolio. We can modestly call ourselves a moderately aggressive
portfolio. Our risk-return profile can be described in figure 2:

Target risk-
return

Figure 2: Portfolio risk and return diagram.

 1.5 Investment constraints

1. Liquidity:

The portfolio must be liquid at any point of time since the investor may have cash
requirements from time to time to meet unexpected expenses. At any point the portfolio
manager must be able to liquidate positions and provide cash to the investors.

2. Time horizon:

The portfolio is constructed for a 5 months’ time horizon with the moderate risk profile and
short term return objective.

3. Other constraints:

The funds goal is not to exceed a 8% risk for a potential 9%-10% profit on the portfolio
returns.

4. Restriction on short-selling:

Sort selling is not permitted, however re-allocation of one asset class after at least 3 months
of tracking is permitted under certain condition.

5. Restriction on usage of derivative products:

No derivatives products are to be used in this portfolio

6. The portfolio is restricted to three securities:

The tax factor is not considering into the Shavron portfolio management.

7. Important dates
January1st 2010 – beginning of the fund

March 1st 2010 – evaluation rebalancing of the fund

April 2nd 2010 – closing of the fund

April 13th 2010 – Final payout to investors.

 2. Asset allocation
One must have often noticed that street vendors often sell apparently unrelated products -
such as umbrellas and sunglasses. After all, when would a person buy both items at the same
time. Probably never - and that's the point. Street vendors know that when it's raining, it's
easier to sell umbrellas but harder to sell sunglasses (Anthony Hatherley, 2009). And when
it's sunny, the reverse is true. By selling both items- in other words, by diversifying the
product line - the vendor can reduce the risk of losing money on any given day. We follow
the ‘Portfolio diversification’ policy for our portfolio, thus ensuring that we meet our investor
goals.

Our asset allocation decision aims to balance the overall portfolio risk and create
diversification by dividing assets into equities and bonds.

Asset class
Stocks – time and again stocks have proven to have the higher risk and higher returns among
the asset categories. As an asset category, stocks are ideal to be a portfolio's "heavy hitter,"
offering the greatest potential for growth thus meeting our objectives. Stocks, not only hit
home runs, but also strike out. The volatility of stocks makes them a very risky investment in
the short term. Yet most of the investor class have been willing to ride out the volatile returns
of stocks over long periods of time generally with a view of being rewarded with positive
returns.

MSCI global indexes sector performance

0.5000000
0.4000000
0.3000000
0.2000000
0.1000000 Mean
0.0000000 Variance
Metal and…
Energy

Software
Metarials
Oil and gas

Textile

Gas

computers
Consumer staple

electric

Water
Real estate
Construction
utilities

Transportation
Industrials

Infrusturcture

comercial bank
Pharmaceuticles

-0.1000000 Std
-0.2000000
Figure 1: Performance of the initially selected sectors of MSCI Index.

0.1500000
Energy

0.1000000
Metarial
s

0.0500000 Oil and

gas

Metal
0.0000000 and
mining
0.00000000.05000000.10000000.15000000.20000000.25000000.30000000.35000000.40000000.4500000
Pharmac
euticles
-0.0500000
Consum
er staple
-0.1000000 utilities

-0.1500000

Figure 2: Sectors position in the performance chart based on the recent market price.

Bonds - Bonds are generally less risky and less volatile than stocks (Natarajan, 2008).
However, bonds have less return as well. As this has risk free interest rate and relatively
stable investment instruments. That is why bonds are ideal assets to support the stability of
the portfolio. Thus bond helps to reduce the risk of holding more bonds would be an
attractive strategy for our investors despite their lower potential for growth. Indeed, equities
are more lucrative in the long run, bonds are more dependable for capital preservation.

Economic and global view

The financial crisis is currently the main issue in the global economy. Almost every major
economy in the world has been affected by the crisis. The crisis starts from the collapse of the
US sub-prime mortgage market and the reversal of the housing boom in other industrialized
economies have had a ripple effect around the world.
Furthermore, other weaknesses in the global financial system have surfaced. Some financial
products and instruments have become so complex and twisted, that as things start to unravel,
trust in the whole system started failing. The extent of this problem has been so severe that
some of the world’s largest financial institutions have collapsed. The crisis became so severe
that after the failure and buyouts of major institutions, the Obama Administration offered a
$700 billion bailout plan for the US financial system. (Akkas, February 28, 2009).

In Europe, the Bank of England pledged US$ 87 billion in direct support to the country’s
major financial institutions. British Prime Minister Gordon Brown’s rescue package which
involves direct capitalization and guarantee of inter-bank lending has been adopted by other
major European countries and the U.S. government. Furthermore, central banks around the
world (Fed, ECB, Canada, Sweden, Switzerland, and China) introduced co-ordinate interest
rate cuts to lower the cost of borrowing, with the aim of restoring confidence in the global
economy.

However, the flipside of the financial turmoil was that the downfall provided extremely low
valuations of many asset categories to levels that had not been seen in years or even decades.
This provided attractive asset prices for 2009 and bargain-hunting became silver lining with
plenty of assets available at sales prices not witnessed in years.

2.2 Why investing in MSCI Index

MSCI index is the diversified and most reliable global equity index maintained by Morgan
Stanley, the one of the most prominent global investment bank. This index is widely use by
the funds and asset managers worldwide. Besides, different investment banks used this index
for the benchmarking purpose of their portfolio
 Chart 1: MSCI index Source: Bloomberg

2.4 Equity selection

Metal and Mining:

Metal and Mining is one the mostly common sectors. The reason behind choosing this sectors
is the current metal and mining industry performance in the global economy. As this metal is
essential to support the growth and mining industry is doing well in the recent years,
particularly for the oil, coal, aluminum and steel etc.

Chart 2: Current market price of Metal and mining sector. Source: Bloomberg.

Materials:

Materials sector is another well performing sector in the MSCI diversified index.
The reason for choosing this sector is, it is performing well in the recent market
and the materials is necessary for the post crisis construction industry around
the world. The following chart illustrates the overall picture.

Chart 3: Graph price of Materials industrial sectors of MSCI Index

Source: Bloomberg.

Textile:

Textile has always been a good sector to invest in. With the growing developing
countries economy, most of the countries concentrate on this sector to develop
which makes this sector well performed. The following charts illustrate the
industry situation.

Chart 4: Textile sectors current market price. Source: Bloomberg.

Utilities:

Utilities are recently doing well in the market as the construction is rapidly
going on in some countries like china, Dubai and India. So, the sectors generally
will do well in the recent future which would be attractive investment sector.

Chart 5: Recent market price performance of Utilities sectors of MSCI index.

Source: Bloomberg.
Pharmaceuticals:

Pharmaceuticals are always been a well performed investing sectors. As the

newly development continuously going on. So, it a better choice of stock in the
MSCI Index.

Chart 6: Market price of Pharmaceuticals sectors of MSCI Index.

Source: Bloomberg.

3. Bond Selection

Bonds are the most reliable source of Investment vehicle among other assets. In this Shavron
portfolio we are considering 3 types of bonds as debts securities (Park, 2008). This debts
instruments are powerful assets in a sense that it has risk free interest rate and it is low risky
investment vehicle. Although many investors doesn’t like to invest in the bonds, however, we
are considering Bonds as an investment instruments to support our portfolio (Qu, 2008) to
reduce the overall risk and diversify the asset classes. We aim to invest in 3 types of bond of
EFFAS index. EFFAS index is the diversified bond index where it is lower risky than the
individual country’s sovereign bonds. As it is diversified. The following chart shows the
EFFAS index bond’s performance.
Chart 7: EFFAS index diversified bond performance. Source: Bloomberg

3.1 Canadian Sovereign bond (EFFAS Index)

Canada is one of the developed countries. In the recent financial crisis it was hardly affected
by the crisis on its economy. Because of its rich mining industry and its stable economy helps
to overcome the crisis relative earlier. The government and political situation is well
established and its bond price is comparably high in the recent market price. According to the
theoretical concept there is an inverse relationship between the country ‘s interest rate and the
bond price. Canada’s interest rate is relative lower to support its economy which cause the
bond price increase since mid of 2009 to 2010. The following chart illustrate the functions of
the bond price.

Chart 8: Canadian bond’s market price of EFFAS Index. Source: Bloomberg.

 3.2 Newzeland Sovereign bond

Newzeland is one of the developed and stable economies in the Asia-Pacific region. We
choose the EFFAS NZ Bond index as the price of the NZ bond price is well performed in the
market. Besides, for the short run investment we consider that it would be one of the ideal
bond instruments for the moderate investors. In chart 9, illustrates the current market price of
the NZ bond of EFFAS Index. And Chart 10 shows the overall recent and past economic
condition of the Newzeland.

Chart 9: EFFAS Index NZ bond market price Source: Bloomberg.

Chart 10: Newzeland economy forecast. Source: Bloomberg.

 3.3 Euro zone bond

Euro zone is one of the well established economic area in the financial world. Although the
recent financial crisis (2007-2009) badly effect the financial market of the Euro zone.
However, some countries like Germany and France and other Scandinavian countries were
not as badly as US or UK affected. However, the lower interest rate and continuous bonds
issue in this area attract the liberal investors to invest in the bond market. In our portfolio we
choose these EFFAS euro zone as this is risk diversified and its high market price which
would helps us to liquid our assets at any point of time.

Chart 11: current market price graph of Euro Zone bond. Source: Bloomberg.

2.5 Data analysis

Here we will discuss how we calculate our individual assets on our portfolio. Once we
collected our data from Bloomberg we calculate the risk and return on each assets weekly
basis, then we turn them on annually. The risk can be calculated as:

Standard deviation:

Portfolio risk measure:

However, the overall portfolio standard deviation is measure as in this portfolio is:
 √∑ ∑ ∑

World Eq.
Bench. Returns S.D. Country
Canadian bond 0.7 3.0 Canada( EFFAS)
Euro Zone bond 6.2 0.2 Euro Zone ( EFFAS)
NZ bond 3.0 0.5 Newzeland (EFFAS)
Metals and mining 40.5 35.5 MSCI INDEX
Materials 48.6 29.3 MSCI INDEX
Textiles 47.8 22.2 MSCI INDEX
Utilities 15.0 12.6 MSCI INDEX
Pharmaceuticals 31.5 12.0 MSCI INDEX

Portfolio Returns %
Canadian bond
Euro Zone bond
NZ bond
Metals and mining
Metarials
Textiles
Utilities
Pharmaceuticles

Risk distribution on Portfolio%

Canadian bond
Euro Zone bond
NZ bond
Metals and mining
Metarials
Textiles
Utilities
Pharmaceuticles

Indeed, when we calculate more than 2 asset’s standard deviation in our portfolio we use the
following model as:
 σρ = [ ∑ i = 1 to n ∑j = 1 to n Xi. Xj. Σ ij] ½
Then to find out the expected return on our portfolio we calculate the return as:

After finding the assets return and the risk we deciding upon the asset classes that this fund is
going to invest in, it is essential to specify the exact securities from each asset class that will
be used. According to the Markowitz optimal portfolio (Anthony, 2008) construction
theory, the element that diversifies risk is the covariance between the risky assets. The
covariance, as described in the following formula is directly linked with the correlation
between the assets multiplied with their standard deviation.

Covariance:

(Please see Appendix 1 for covariance Matrix table)

Correlation comes to mind when we think about the benefits of diversification (Zhang,
2008) of different assets class because increasing the correlation diminish the benefits of
diversification. The smaller the correlation between the securities, the lower covariance we
will receive .So our first step is to gather securities from the asset classes we have picked and
calculate a correlation matrix .The qualities that the securities had in order to be part of this
matrix were high performance, median or low volatility and liquidity .The final correlation
matrix chosen by the fund is:

Correlation:

(Please see Appendix 2 for Correlation Matrix table)

But the statistical data by themselves cannot back up the funds decision to proceed in
constructing a portfolio based only on this information (Gintschel, 2008). Economic data
provides evidence of the goodness-of-pick from this correlation matrix.
We also use the following model to sort out the minimum variance of our portfolio. This is as
follows:

+ (i.e. 2
securities)

Based on the calculation our portfolio assets performed as follows:

Bonds performance:

Mean Variance STD.

Canadian Bond 0.01 0.00086 0.03
Eurozone Bond 0.06 0.00 0.00
NZ Bond 0.03 0.00 0.01

0.07
0.06
0.05 Canadian Bond
0.04
Eurozone Bond
0.03
NZ Bond
0.02
0.01
0.00
Mean Variance STD.

Debts instruments performance on

Portfolio
3.50
3.00 0.67, 2.97
Bond return%

2.50
2.00
1.50 Debts instruments
1.00 performance on
Portfolio
0.50 2.96, 0.50
6.16, 0.20
0.00
0.00 2.00 4.00 6.00 8.00
Bond risk%

Equity Performance:
 Mean Variance STD.
Metal and
Mining 0.40 0.12 0.36
Materials 0.49 0.08 0.29
Textile 0.48 0.05 0.22
Utilities 0.15 0.02 0.13
Pharmaceutics 0.31 0.01 0.12

Equity sector performance

0.50

0.00
Metal Metaria Textile Utilities Pharma
and ls ceutices
Mining
Mean 0.40 0.49 0.48 0.15 0.31
Variance 0.12 0.08 0.05 0.02 0.01
STD. 0.36 0.29 0.22 0.13 0.12

Overall Portfolio’s individual asset’s return is:

Sector's performance of the Portfolio

0.40

0.35 0.40, 0.36

Portfolio Return %

0.30 0.49, 0.29 EFFAS Canadian Bond

0.25 EFFA Euro zone Bond
0.48, 0.22
EFFAS NZ Bond
0.20
Metal and Mining
0.15
Metarials
0.15, 0.13 0.31, 0.12
0.10 Textile
Utilities
0.05
0.01, 0.03 Pharmaceuticals
0.00 0.03, 0.01
0.06, 0.00
0.00 0.10 0.20 0.30 0.40 0.50 0.60

Portfolio Risk %
 4. Portfolio construction

After analyzing the reasons, both statistically and economically, of choosing the specific
securities and assets it essential for the fund manager to find a way to forecast expected
returns and expected risk (KUMAR, 2008) .A common way used to forecast such data is by
using historic data from the securities in the portfolio.
The following model can be used to forecast the expected return on equities.

Expected return =∑

Beside, the variance of returns for risky assets such as equities could be described
as:

Indeed, Bonds are fixed income securities. So, bonds price are less volatile then the equity. It
also less risky with less return. However, the calculation for the fixed income is a bit different
from the equities. Here, in our portfolio we follow the following models to calculate the
price volatility and convexity of our bonds (Fask, 2008). Particularly a bond
which varies inversely with its coupon and directly with its term to maturity, it
is may necessary to determine the best combination of these two variables to
achieve the objective. The model is as follows:

∑ ∑
=
∑

Determinants of Convexity:

Convexity is a measure of the curvature of the price-yield relationship (C.Brown,

2003). Mathematically, Convexity is the second derivative of price with respect
to yield divided by price. Specifically, convexity is the percentage change in
⁄ for a given change in yield.
 Convexity =

The Bond holding period yield (HPY) is:

In this scenario we calculate the future bond price by applying the following
model in our portfolio.

∑
( ) ( )

However, in the future bond price calculation inflation rate of a country is very important.
Although in our portfolio we did not consider the inflation and interest rate as because it was
not instructed. But we are considering to tell the investors about the inflation rate calculation
model which helps them to analyze the future price with inflation of the currency.

1. Rate of Inflation:

2. Throughout this market, A bond price change is measured as the

percentage change in the price of the bond, computed as follows:

Percentage change is Bond price =

Here,

EPB = The ending price of the Bond

BPB = The beginning price of the Bond

Indeed, the larger the variance for an expected rates of return on portfolio, the
greater the dispersion of expected returns and the greater the uncertainty on
risk of the investment (Chow, 2008), the variance or risk of the investment. The
variance of the perfect certainty would be:
 ∑

3. Expected return of a portfolio:

Obviously, such an estimate contains a great deal of uncertainty. In order to use this way of
forecasting one must assume that the returns are normally distributed (Sharpe, 1995).

In this situation This time horizon was selected in order to include at least one whole
economic cycle and provide as much feedback on the reaction of the securities during all
holding periods. The data are weekly and denominated in the currency of the funds
country of origin (USD$).

Firstly we must calculate the weekly returns and the standard deviation:

Returns=ln (

∑ ̅̅̅
σ=√

After calculating the monthly returns for the past 1 year we must annualize them as well as
the standard deviation:

Annual Returns = √ ̅̅̅̅̅̅̅̅̅̅̅̅ -1

Annual standard dev. = σ

The goal of the manager is to minimize his expected risk and maximize his expected returns.
The standard dev. of the three securities of our portfolio is equal to:

=∑ ∑ (A)
The expected return of the portfolio is equal to the sum of each security times the weight
they have in it.

∑ (B)

So are next step is to Minimize equation (A) and Maximize equation(B) at the same time .As
the expected returns have already been calculated the only thing left to alter in order to reach
an efficient portfolio is the weights of the securities. In order to select our optimum portfolio
we insert into the equations different expected returns so we can find the weights that
minimize the risk we must endeavor.

The efficient frontier

Sharp ration of Portfolio
securities
4
3.5
3
2.5
2
SHARP RATIO
1.5
1
0.5
0
0 2 4 6 8 10

S ER SHARP RATIO
3.0 0.7 0.224398649
0.2 6.2 30.7711
0.5 3.0 5.90844
35.5 40.5 1.138913851
29.3 48.6 1.656799317
22.2 47.8 2.149087719
12.6 15.0 1.186049206
12.0 31.5 2.632459866
A portfolio is considered efficient if it is not possible to obtain a higher return without
increasing standard deviation.

Portfolio Efficient Frontier

30

25
Portfolio Return (%)

20

15

10

0
0 5 10 15 20 25 30 35
Portfolio Risk (%)

This is the efficient frontier line as described in the Markowitz portfolio theory .Every
point on this line is efficient for the investor (Özekici, 2008). To compute points along the
efficient frontier we use the Excel Solver which helps us to find the objective of portfolio.
Once bring up Solver, you are asked to enter the cell of the target (objective) function. In our
application, the target is the variance of the portfolio, given in cell C56. Solver will minimize
this target.

Perfect positive correlation is the only case in which there is no benefit from
diversification. With any correlation coefficient less than 1.0(   1 ), there will be a
diversification effect, the portfolio standard deviation is less than the weighted average of the
standard deviations of the component securities. Therefore, there are benefits to
diversification whenever asset returns are less than perfectly correlated. Negative correlation
between a pair of assets is also possible. Where negative correlation is present, there will be
even greater diversification benefits.
 Expected Return

0   1

0
Standard Deviation

Figure 5: Investment opportunity sets for our portfolio with various correlation
coefficients between different securities.

U2
B
Expected Return

U1

Minimum
variance
Efficient
portfolio
frontier of

risky assets
0 Standard Deviation

Figure 6: Indifference Curves and Efficient frontier

In order to simplify the determination of optimal risky portfolio, we use the capital allocation
line (CAL), which depicts all feasible risk-return combinations available from different asset
allocation choices, to determine the optimal risky portfolio. To start, however, we will
demonstrate the solution of the portfolio construction problem with only two risky assets (in
our example, asset A and asset B) and a risk-free asset. In this case, we can derive an explicit
formula for the weights of each asset in the optimal portfolio. This will make it easy to
illustrate some of the general issues pertaining to portfolio optimization.

The solution shows that the optimal position in the risky asset is, as one would expect,
inversely proportional to the level of risk aversion and the level of risk (measured by the
variance) and directly proportional to the risk premium offered by the risky asset. Once we
have reached this point, generalizing to the case of many risky assets is straightforward.
Before we move on, let us briefly summarize the steps we followed to arrive at the complete
portfolio.

1. Specify the return characteristics of all securities (expected returns, variances,

covariance).
2. Establish the risky portfolio:
a. Calculate the optimal risky portfolio S.
b. Calculate the properties of portfolio S using the weights determined in step
and equations X.5 and X.13.
3. Allocation funds between the risky portfolio and the risk-free asset:
a. Calculate the fraction of the complete portfolio allocated to Portfolio S (the
risky portfolio) and to risk-free asset (equation X.14).
b. Calculate the share of the complete portfolio invested in each asset and in
risk-free asset.

CAL

Indifference Curve
Expected Return

Opportunity Set of Risky

Assets

Optimal Risky Portfolio

rf Optimal

Complete
0
Portfolio Standard Deviation

Figure7: Determination of the optimal portfolio

 6. Computing return

In this stage, we now compute the portfolio returns over the last three months by following a
step by step procedure:

Step1: Compute each securities return using the following formula

Returns = (9)

Step2: Compute the portfolio’s return with the use of formula (8) (shown previously)

After completing the above calculation we will derive the following table

Portfolio securities Weights Return

Canadian bond 3.19 0.7
Euro Zone bond 0.19 6.2
NZ bond 0.58 3.0
Metals and mining 43.29 40.5
Materials 37 48.6
Textiles 28.9 47.8
Utilities 15.47 15.0
Pharmaceuticles 14.92 31.5

7. Benchmarking

From the above different models and calculation, we observe that our performance is
relatively better than the earlier portfolio performed .Although there is still opportunity to
observe the data from the market as the industry sectors continuously fluctuate but positive
sign for the portfolio is the constant growing of the value, we compare the performance to the
benchmark, in order to see the true value of it, by determining if its returns are better than that
of the benchmark.
It must be noted that the benchmark is a synthetic boundary that is constructed from the equal
weights of the securities in the portfolio.

By the end of March the fund manager’s view has changed considering the bond market and
he decides to proceed in a re-allocation from Brazilian individual sovereign bond to EFFAS
indexed Canadian and Euro zone bond which are more diversified and comparably higher
returned. This has as a consequence to repeat the construction of the portfolio from the
beginning . .Because in our original correlation matrix we had used data from more than just
different countries individual bond. We will now pick the immediate best correlated after the
polish government bond that we substituted. In the following graph illustrate the portfolio
securities weights compare with the targeted bench mark.

50
45
40
35
30
25
20
15 Portfolio
10
5 Benchmark
0

Figure: Benchmarking with our portfolio securities’ weights. We found that our portfolio weights
relative constant and better. Performed.
 9. Decision on Investment

The rationale behind the picking of the securities included in this mutual fund portfolio was
presented in the earlier of this report. Although the decisions were well based on the
interpretations of economic and statistical data a deviation was observed after calculating the
market’s performance.

At the beginning we selected the well performed equities from the MSCI index about 18 of
the equities has been selected. The we tried to identify the problem we can refer to the poor
data selection, although the prices were as updated but their market performance based on our
calculation doesn’t satisfy us. On the other hand, the bright side of our selection was the good
weighting of our securities which entitled us to beat the artificial benchmark created to
compare our performance. For the second period of our project we re-allocated one of our
securities for two reasons. The first is that the returns in contrast with the risk do not satisfy
our policy making the bond not desirable for our portfolio after the first three months. On top
of that our view of the market had changed and that has led us to believe that the three bonds
mentioned in chapter 4.2 if allocated in our portfolio will give higher returns than the
previous one. To strengthen this opinion, we would suggest the investors that the last 3 month
trend in the correlation between our Euro zone bond and the Newzeland bond of EFFAS
Index is comradely better. From the optimal portfolio construction theory it is known that low
correlations are a way to diversify the risk between our assets. For all the above reasons our
fund went on with substitution of the Bond Index. Although this was a breakthrough
comparing to the first period the total gains did not manage to coop with the funds policy .To
make matters worse the benchmark that measures the performance was not beaten showing
weak weighting in our portfolio securities. The argument to this is that the weighting of the
portfolio was based on minimizing expected risk and maximizing expected return. The
problem is seen in the poorness of the model or use of historical economic data.

In future projects it is strongly advised that the use of more than one measures of expected
return and risk is used and a larger scale of economic data from the securities selected in
order for a more accurate forecast of future movements. This model over estimated risk and
under estimated returns leading to these weightings in the last 3 months.
 10. Reference

1. kkas, D. S. (February 28, 2009). Review of Global Financial Crisis 2008: Issues,
Analytical Approaches and Interventions.

2. Anthony Hatherley, J. A. (2009). Portfolio construction incorporating asymmetric

dependence structures: a user’s guide. Journal of Accounting and Finance .

3. Anthony, L. (2008). Why Risk Is Not Variance: An Expository Note. Journal of risk
analysis.

4. C.Brown, F. K. (2003). Investment analysis and portfolio management. Thomson.

5. Chow, K. V. (2008). Style Fund Investment: Performance and Efficiency.

6. Fask, A. (2008). OPTIMIZING THE RETURN ON INVESTMENTS FOR

PHARMACEUTICAL PROMOTIONAL EXPENDITURES.

7. Gintschel, A. (2008). Optimal asset allocation for sovereign wealth funds.

KUMAR, W. N. (2008). Equity Portfolio Diversification.

8. Natarajan, K. (2008). Incorporating Asymmetric Distributional Information in Robust

Value-at-Risk Optimization. Journal of management science .

9. Özekici, E. Ç. (2008). Portfolio selection in stochastic markets with exponential utility

functions.

10. Park, A. K. (2008). OPTIMAL PORTFOLIO DIVERSIFICATION USING THE

MAXIMUM ENTROPY PRINCIPLE.

11. Qu, X. M. (2008). Robust portfolio optimization with a generalized expected utility model
under ambiguity.

12. Sharpe, W. F. (1995). Investment. Prentice Hall.

13. Zhang, L. B. (2008). Dynamic mean-variance problem with constrained risk.

 Metals Euro
Pharmac and Zone Canadian
euticals Utilities Textiles Materials mining NZ bond bond bond

Canadian
19.79 24.05 38.63 58.34 53.48 0.76 0.25 8.76 bond

Euro
Zone
1.14 1.34 1.70 2.23 5.11 0.07 0.04 0.25 bond

Covarian
3.60 4.00 6.04 7.38 15.28 0.25 0.07 0.76 NZ bond ce Matrix

Metals
and
242.36 280.46 435.00 477.12 1261.67 15.28 5.11 53.48 mining
Appendix 1: Covariance Matrix

233.80 225.91 504.90 858.49 477.12 7.38 2.23 58.34 Materials

192.57 176.58 494.17 504.90 435.00 6.04 1.70 38.63 Textiles

118.73 158.76 176.58 225.91 280.46 4.00 1.34 24.05 Utilities

Pharmac
143.04 118.73 192.57 233.80 242.36 3.60 1.14 19.79 euticals
1.000 0.125 0.125 0.125 0.125 0.125 0.125 0.125 0.125 Weights

Canadia
3.19 0.31 0.38 0.60 0.91 0.84 0.01 0.00 0.14 0.125 n bond

Euro
Zone
0.19 0.02 0.02 0.03 0.03 0.08 0.00 0.00 0.00 0.125 bond

Shavron
Covaria
nce
0.58 0.06 0.06 0.09 0.12 0.24 0.00 0.00 0.01 0.125 NZ bond Matrix:
Equally
Metals Weighte
and d
43.29 3.79 4.38 6.80 7.46 19.71 0.24 0.08 0.84 0.125 mining Portfolio

37.00 3.65 3.53 7.89 13.41 7.46 0.12 0.03 0.91 0.125 Materials

28.90 3.01 2.76 7.72 7.89 6.80 0.09 0.03 0.60 0.125 Textiles
Appendix 2: Shavron Portfolio individual assets Weights:

15.47 1.86 2.48 2.76 3.53 4.38 0.06 0.02 0.38 0.125 Utilities

Pharmac
14.92 2.24 1.86 3.01 3.65 3.79 0.06 0.02 0.31 0.125 euticals
1.0000 0.4903 0.0833 0.0000 0.0000 0.0000 0.1437 0.1275 0.1552 Weights
return.

Canadia
2.05 1.51 0.31 0.00 0.00 0.00 0.02 0.00 0.21 0.16 n bond

Euro
Zone
0.09 0.07 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.13 bond Bordere
d
Covaria
0.32 0.25 0.05 0.00 0.00 0.00 0.01 0.00 0.02 0.14 NZ bond
nce
Matrix:
Target
Metals Return
and Portfoli
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 mining o

Material
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 s

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Textiles

6.32 4.85 1.10 0.00 0.00 0.00 0.05 0.01 0.31 0.08 Utilities
Appendix 3: Targeted weighted portfolio at 25% minimum

Pharma
41.07 34.39 4.85 0.00 0.00 0.00 0.25 0.07 1.51 0.49 ceuticals
 Appendix: 4

1. Metal and Mining

Chat 1: Beta regression analysis of MSCI Index Source: Bloomberg

Chart 2: Correlation of MSCI Materials sector . Source: Bloomberg

Chart : MSCI Metal and Mining sector ratio analysis Source: Bloomberg

Chart : MSCI metal and mining index Spread analysis. Source: Bloomberg.
 Appendix 5
2. Materials ( MSCI index)

Chart: Beta regression analysis of Material sector . Source: Bloomberg.

Chart: Correlation of Material sector. Source: Bloomberg.

Chart: Material sector spread analysis. Source: Bloomberg.

Chart: Ratio analysis of material sector. Source: Bloomberg

 Appendix 6

3. Textile Sector of MSCI index

Chart: Beta analysis of MSCI textile sector. Source: Bloomberg.

Chart: Correlation of the MSCI textile sector. Source: Bloomberg.

Chart: MSCI Textile spread analysis. Source: Bloomberg.

Chart : MSCI Ratio analysis of Textile sector. Source: Bloomberg

Appendix 7
4. Utilities

Chart: MSCI Utilities sector Beta analysis. Source: Bloomberg

Chart: MSCI Utilities correlation. Source: Bloomberg.

Chart: Utilities Spread analysis. Source: Bloomberg.

Chart: Ratio analysis. Source: Bloomberg.

Appendix 8

MSCI Pharmaceuticals Sector

Chart: Beta analysis of MSCI Pharmaceutical sector. Source: Bloomberg

Chart: Correlation of Pharmaceutical sector

Chart: MSCI Pharmaceutical sector spread analysis. Source: Bloomberg.

Appendix 9

EFFAS (Australian government bond)

Chart: EFFAS Australian bond yield analysis

Chart : Correlation of EFFAS AUS Bond Index.

Chart : Aus Bond Beta analysis. Source: Bloomberg.

Appendix 10
EFFAS (Newzeland government bond)

Chart : EFFAS NZ Bond index’s Beta analysis. Source:

Bloomberg

Chart : EFFAS NZ Bond correlation. Source: Bloomberg

Chart : EFFAS NZ Bond Ratio analysis. Source: Bloomberg.

Appendix 11
Euro zone bond (EFFAS index)

Chart: Euro Zone bond Scenario of EFFAS index.