Basics of Portfolio Planning and Construction: practice question
Lakemont University endowment — two-fund allocation
Danielle Osei, CFA, is a portfolio manager at Whitmore & Vale Advisors, where she is responsible for the Lakemont University endowment. The endowment distributes 4% of its market value each year to fund scholarships, pays no income taxes, and has an essentially perpetual time horizon. Osei is updating the endowment's investment policy statement while she evaluates a simple two-fund allocation for the portfolio.
The proposed allocation places 60% of the endowment in the Norcliff Global Equity Fund and 40% in the Ardenmead Bond Fund. Osei's capital market assumptions, together with each fund's expected return, standard deviation, beta, and proposed weight, are shown in Exhibits 1 and 2. She assumes returns on the two funds are jointly normally distributed.
Osei computes the combined portfolio's expected return and standard deviation, derives its beta and the return the capital asset pricing model requires, and ranks the three investments with the Sharpe and Treynor measures before finalizing her recommendation to the endowment's trustees.
| Fund | Expected return | Standard deviation | Beta | Weight |
|---|---|---|---|---|
| Norcliff Global Equity Fund | 12.0% | 20.0% | 1.20 | 60% |
| Ardenmead Bond Fund | 6.0% | 8.0% | 0.50 | 40% |
| Assumption | Value |
|---|---|
| Risk-free rate | 3.0% |
| Expected return on the market portfolio | 9.0% |
| Correlation between the two funds' returns | 0.25 |
In drafting the revised investment policy statement, which item is most appropriately classified as a constraint rather than an investment objective?
- The endowment's obligation to distribute 4% of portfolio value each year
- The endowment's willingness and ability to bear investment risk
- The endowment's required long-term return
Show answer and explanation
Correct answer: A
Explanation: The annual 4% spending requirement forces part of the portfolio to be readily marketable, making it a liquidity constraint, one of the factors that limit how the objectives can be pursued. Willingness and ability to bear risk is the risk objective, one of the two core elements of an IPS. The required long-term return is the return objective, the second of those core elements.
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