Evaluation of Hewlett Foundation Asset Allocation Decision Process - Case Study Example

?Running Head: Hewlett Foundation Case Study Hewlett Foundation Case Study Hewlett Foundation Case Study Introduction An asset allocation decision involves an evaluation of a portfolio. The analysis of each portfolio helps an investor in making a decision when investing (Reilly & Brown, 2011). Most likely, a rational investor will choose the best portfolio and screen out the ones that are not essential based on objective criteria. A good portfolio is characterized by high returns on investment (Brigham & Joel, 2009). Portfolio analysis requires subjective judgment as it is not easy to segment different industries. In this report, we will evaluate investments options that have been suggested by the asset allocation committee of Hewlett foundation (HF). We will ascertain whether the committee has taken the right track in its investment decision. The report will also evaluate the decision process that the committee uses. 1.1 Evaluation of Hewlett foundation (HF) asset allocation decision process The asset allocation policies are formulated by the foundation, internally managed but uses external manager to invest the portfolio. The external managers can either invest 100% of the asset in indexed instruments or invest partially depending on the allocation method. There are four methods that the foundation uses in evaluating the performance of its portfolio. To begin with, it uses a benchmark with which it compares the performance of each asset. If the portfolio outperforms its benchmark, then it is a worth portfolio to invest in. on the other hand, if its performance is less than that of the benchmark, then it’s not a worth portfolio (Keith et.al, 2011). The second is comparing the performance of HF ‘composite benchmark’ with that of U.S stocks and bonds. The other method is by comparing performance of its portfolio relative to that of other tax-exempt institutions. Finally, accessing whether the return on assets exceeds the rate of inflation It is evident that the process does not use the mean-variance optimization method in the process. It is the most accurate method in analyzing portfolios as it incorporates risk and returns (Goetzmann at.al, 2006). Therefore, it is recommendable for HF to consider using it in asset allocation process. 1.2 Decision-making framework Proposal 2 In this option, 5% of the assets will be committed to a global distressed real estate fund. In order to assess the viability of this investment, the allocation committee should use discounted cash flows (DCF) models such as the Net present Value and the interest rate of return (IRR) (Goetzmann at.al, 2006). These methods take into account the aspect of time value for money and make use of cash flows not profits. The process starts by accessing the initial investment costs and then projecting cash flows. The project is acceptable if the NPV is greater than one meaning that the discounted cash flows should be greater than the initial cost of the investment. In the case for IRR, the investment is acceptable if IRR is greater than the required rate of return and vice versa. Proposal 1 In this proposal, the committee aim is to reduce the foundation’s exposure to domestic equities, and instead increase this allocation to absolute return strategies and US TIPS (Treasury Inflation Protected Securities). TIPS are short term investments which are risk free. Therefore, they can use Capital asset pricing model (CAPM) in decision making. CAPM is a theoretical model used to determine the required rate of return of an asset. It also considers the risk free asset. Once the required rate of return (Ri) is calculated using the CAPM model, it is compared to the assets estimated rate return over a specific investment horizon to determine the viability of the investment. That is, whether the investment is worth to take. For such comparisons, technical analysis techniques such as the price earning ratio (P/E) can be used. Generally, an asset is said to be well priced if the estimated price is same as the required rates of return solved using the CAPM. If the estimated price is higher than the required rate of return, this is an undervaluation. If the estimated price is lower than the required rate of return then the asset is said to be overvalued. 1.3 Other investment option The other option that I would suggest is by investing in futures such as the stock index futures and commodity futures. Futures involve a contract between two parties to sell or buy an asset at a predetermined price and at a specific date. They standardized as they indicate when to trade, what to trade and where to trade (Goetzmann at.al, 2006). Futures are useful in hedging risk. There are so many uncertainties in the market thus by locking in the price; the hedger is able to eliminate the ambiguity associated with price fluctuations. The problem with hedging is that it requires a deep understanding of complex relationships and if not priced well hedging might not work. 1.4 Risk measurement Portfolio analysis is a process as different financial instruments have to be evaluated one by one. The process of determining risk is time consuming and involves a lot of effort. In spite of this odds, Markowitz the fonder of modern portfolio analysis has simplified the process by suggesting use of expected return and variance (Keith et.al, 2011). Therefore, in measuring the level of risk, I would use the mean-variance method. This is because it involves determination of standard deviation. Basically, standard deviation determines the degree of risk that is associated with the portfolio (Markowitz, 2000). It uses weights of individual assets. When the standard deviation is less, the level of risk is also low and high then the level of risk is high. The mean-variance method was first derived by Markowitz in 1952. I agree with the recommendations by the allocation committee. The asset allocation committee has considered the aspect of diversification. A large number of its investments were in stocks, but now it is considering taking other options. That is by investing 5% of its assets to a global distressed real estate fund and in absolute return strategies and U.S treasury Inflation protected securities. It is risky to put all your investments in one basket (Goetzmann at.al, 2006). Diversification helps in spreading risk and for any rational investor this is not an option but an obligation. A portfolio contains the systematic/market/non-diversifiable risk and the diversifiable risk. The market risk which relates to individual risks while, the diversifiable risk common to all assets. The diversifiable risk is reduced by including a greater number of securities in a portfolio. As for the market risk, this is not possible in the same market due to the effect of market volatility. The effect of market volatility increases the level of risk (Markowitz, 2000). Generally, a well diversified portfolio best suits the long-term growth of your investments. It protects assets from risks that arise as a result of market fluctuations. It is recommendable for any investor to monitor the diversification of his portfolio and make adjustments when necessary to increase chances of long-term financial success. One has to ensure that a given class of asset is spread across different sectors and subclasses. Diversification helps investors have a range of assets that satisfy their needs. Conclusion The committee has tabled how it’s going to allocate its assets. This is not enough as the each investment option has to be evaluated in order to determine their viability. It is recommendable for the asset allocation committee to make use of investment appraisal techniques in assessing each investment. It should also consider expected returns and risks of these investments. References Reilly, Frank, Brown, Keith, (2011). Investment Analysis and Portfolio Management. Cengage learning. Eugene F. Brigham, Joel F. Houston, (2009). Fundamentals of Financial Management. cengage learning. Birt and Gregory Boland, (2010). Accounting: Business Reporting for Decision Making. Wiley and sons publishers. Bartol, Kathryn M., (2011). Management: A Pacific Rim Focus.6th Edition. McGraw- Hill Australia, 2011. Harry M. Markowitz, G. Peter Todd, (2000). Mean-Variance Analysis in Portfolio Choice and Capital Markets. 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