Question

19. The year is 2006. You are the manager of a university endowment and are combining stocks, bonds, and real estate funds. Your mandate is to find the optimal portfolio that has an expected return of 8% per year. What optimization problem would you try to solve?

Minimize risk for an expected portfolio return of 8% per year

Maximize expected return for a volatility target of 8% per year

None of these

Maximize the Sharpe ratio with no constraints

Not enough information

20. Assume you only have five years of real estate fund data. The optimization from the previous problem (#19) directs you to invest 90% in real estate funds, 10% in bonds, and 0% in stocks. Which of the following is the most likely cause of the extreme weight in real estate funds?

Bonds have very low returns, so portfolios with high Sharpe ratios rarely contain bonds.

Real estate is a great investment that is overlooked by many investors so it is chronically undervalued.

Real estate had an unusually good �five year performance through 2006

Stocks are very volatile, so mean-variance optimization would rarely recommend much investment in stocks.

21.

Which of the following is not a good potential method to the get a more reasonable portfolio than the one produced by the optimization in #20.

Instead of aggregating stocks into a single asset, let the optimizer select from real estate funds, bonds, and individual stocks.

Make more reasonable assumptions about what expected returns on real estate will be going forward relative to the prior five years

Constrain the maximum weight on real estate

Obtain a longer history of real estate fund data

Identify a statistical technique that generates better estimates of expected returns than sample averages

Answer 1

Ques 19: Option A

The question states that we are required to construct an optimal portfolio which will give an expected return of 8%.

As a rational investor always aims to achieve his/her target return by taking minimum risk, hence, in this case, we should minimize risk for an expected portfolio return of 8% per year.

Option B is incorrect as the Question does not mention that the target risk level is 8% per year.

Option D is incorrect because the question specifically asks to construct a portfolio with 8% return p.a. Hence this has to be taken into account.