Harvard Management Company Business Analysis

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The optimum portfolio consisted of an investment of 61.25% in domestic equity and 38.75% in domestic bonds. The excess return of the portfolio was 2.15% with a standard deviation of 11.16%, giving us a Sharpe ratio of 0.192. This differs to the answer above because excess return has to be maximized in order to maximize the Sharpe ratio and that can only be achieved through a majority stake in equities. This strategy will be preferred if the Board is relatively risk-loving.

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Q5: If the Board allowed HMC to add commodities to the mix, would you advise them to add this asset class? Why?

We would advise the board to add commodities to the portfolio because they are negatively correlated to both domestic bonds and equity asset classes thus taking advantage of the benefits of diversification. This also increases the portfolio Sharpe ratio making it an ideal addition.

The Global minimum variance portfolio resulted in an investment of 1.01% in domestic equity, 70.79% in domestic bonds and 20.2% in commodities. The excess return of the portfolio was 0.88% with a standard deviation of 5.62% giving us a Sharpe ratio of 0.156. Adding commodities also decreases the risk of the Global minimum variance portfolio.

The optimum portfolio consisted of an investment of 51.72% in domestic equity, 17.2% in domestic bonds and 31.08% in commodities. The excess return of the portfolio was 2.00% with a standard deviation of 9.35%, giving us a Sharpe ratio of 0.214. Although excess return decreased when adding commodities, risk decreased more in comparison and therefore increased our Sharpe ratio.

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Q6: How would you advise HMC to combine cash with a portfolio of domestic equities, bonds, and possibly commodities?

We would advise the board to add cash to the above mentioned portfolio since this leads to an increase in the Sharpe ratio from 0.214 to 0.217. To achieve our target goal of 6-7% real return, we need to obtain 3% in excess returns. Our recommendation is as follows:

- Domestic Equity – 67.11%

- Domestic Bonds – 57.13%

- Commodities – 53.97%

- Cash – Short 78.2%

This portfolio will get a 3% excess return with a standard deviation of 13.89%. We need to borrow cash to invest in the above mentioned securities. This is because leverage lets us get higher returns compared to the portfolio without cash.

Q7: HMC is considering investing in this new type of bond that the US Treasury has just issued. What characteristics of the bond do you think they should consider when deciding whether to invest in it or not?

US Treasury Inflation Protected Securities are bonds whose principal and coupons grow with the general level of prices as measured by the Consumer Price Index (CPI). These securities therefore give investors protection against the eroding effects of inflation on the value of money.

Until TIPS came along, most bonds required a fixed amount invested upfront in exchange for interest payments during the bond's term. At maturity, principal amount would be returned. As a result, investors knew exactly how much they'd get in payments. But by the time the bond matured, that initial fixed amount would have a lot less purchasing power. There the inflation protection characteristic is an important aspect to consider during investment.

A potential downside of this characteristic is that investors usually expect inflation to rise and hence interest rates on TIPS could be lower than other bonds in the market. Yet if you want inflation protection, giving up some current income to ensure that the principal amount is protected is worth it.

Another crucial factor to consider is taxation. The inflation-adjustment to the principal is taxed at the federal level in the period in which it is made. This could have a big effect on overall returns if taxation policy is unfavorable to investors.