Financial Risk Manager Part 2
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An individual investor is planning to allocate USD 8 million to either exchange-traded funds (ETFs) or private equity funds (PEFs). To make an informed decision, the investor gathers the past year's returns for a variety of ETFs and calculates statistical measures such as volatility and correlation using these returns. The investor also analyzes a database containing reported returns and volatilities for several PEFs and narrows down the choices to two potential investments in each category. Based on the collected data, the investor compiles the following information for the four possible investments:
| 1-year Annual return | Volatility of returns | Asset |
|---|---|---|
| 6.5% | 11.4% | Broad equity market index ETF (ETF1) |
| 8.3% | 13.6% | Growth stock ETF (ETF2) |
| 7.4% | 12.3% | Private equity fund 1 (PEF1) |
| 10.2% | 11.1% | Private equity fund 2 (PEF2) |
| Correlation of returns | Asset 1 | Asset 2 |
|---|---|---|
| 0.67 | ETF1 | ETF2 |
| 0.25 | ETF1 | PEF1 |
| 0.41 | PEF1 | PEF2 |
The investor reviews this data, considering potential biases and uncertainties in the reported figures. What would be the most suitable conclusion for the investor to draw?
Explanation:
D is correct. Because private equity funds trade infrequently, their risk measures-such as volatilities, correlations, and betas--can be too low when computed using reported returns. See p. 386 in LTR and p.86 in IM. A is incorrect. Correlations regarding PEF1 are not reliable (See explanation for D). The correlation between the two ETFs is more reliable. B is incorrect. Because the volatility of PEF2 is likely understated, it is not clear that PEF2 truly has the best return to risk profile out of the four investments. Even if it did in fact have the best return/risk profile, it is inappropriate to conclude that the investor should allocate all these funds to that one investment. The investor should consider other factors, such as potential diversification benefits from holding a mixture of the four investments as well as diversification benefits with other investments and asset classes that the investor may own. There is not enough information given to make this conclusion.