Funds Managment

Topic 2 – Investment Policy Statement

Question 1

a. The Maclins’ overall risk objective must consider both willingness and ability to take risk.

Willingness: The Maclins have a below-average willingness to take risk, based on their unhappiness with the portfolio volatility in recent years and their desire to avoid shortfall risk in excess of –12 percent return in any one year in the value of the investment portfolio.

Ability: The Maclins have an average ability to take risk. While their large asset base and a long time horizon would otherwise suggest an above-average ability to take risk, their living expenses ($74,000) are significantly greater than Christopher’s after-tax salary ($48,000), causing them to be very dependent on projected portfolio returns to cover the difference, and thereby reducing their ability to take risk.

Overall: The Maclins’ overall risk tolerance is below average, as their below-average willingness to take risk dominates their average ability to take risk in determining their overall risk tolerance.

b. The Maclins’ return objective is to grow the portfolio to meet their educational and retirement needs as well as to provide for ongoing net expenses. The Maclins will require annual after-tax cash flows of $26,000 (calculated below) to cover ongoing net expenses, and they will need $2 million in 18 years to fund their children’s education and their own retirement. To meet this objective, the Maclins’ pre-tax required return is 7.38 percent, which is calculated below.

The after-tax return required to accumulate $2 million in 18 years, beginning with an investable base of $1,235,000 (calculated below) and with annual outflows of $26,000, is 4.427 percent. When adjusted for the 40 percent tax rate, this results in a 7.38 percent pretax return: 4.427%/(1 − 0.40) = 7.38%. (Note: we simply use 40% to work out the pre-tax return as the question assumes that the tax rate is constant....