Pitech's customers are mainly U.S. firms, but the company has begun to get international orders. The future international demand for their product looks good, and the patent rights on their principal product appear secure. Finnerty and his colleagues are currently at work on extensions of the basic technology which will make it applicable to "smart cars." General Motors is now interested in their product and expertise.
Walter earns $100,000 per year in salary and gets annual bonuses in the form of executive options tied to stock price performance. In 1995 his stock options suddenly became worth $3.5 million, when Pitech went public. Walter exercised one set of Pitech stock options for pennies on the dollar, and now has a brokerage account with 100,000 shares which trade regularly but thinly on the NASDAQ -- earning no dividends and fluctuating wildly as the hitech stocks have jumped up and down over the past 24 months. Twenty percent of the firm's shares are owned by Tyler and Camber Cobb, the two brothers who started the company. They originally developed the technology with backing from Technikron, a venture capital firm specializing in computer start-ups. Technikron engineered the IPO of Pitech last year.
This year, although the stock was at its all-time high of $12/share in June, the Cobb brothers decided to diversify their personal holdings, and Finnerty decided to do the same. The Cobbs' invested in a mixed bag of assets, selling half of their shares to buy a hilltop overlooking the village of Monte Sereno, $20 million of California municipal bonds, a steak restaurant in San Francisco and some minor impressionist paintings from a New York dealer.
Walter Finnerty's idea of diversification was different. He was interested in the long-term growth and predictability of a diversified portfolio of equities. He also had heard of the benefits of international investing -- in particular, the reduction of risk. Finnerty had been following international equity indices like EAFE, as well as emerging market funds. While his basic investment plan was to put all of his money into equities, he thought it might be worth considering a significant proportion in overseas stocks.
Tamara Razi is a certified financial planner. She was recommended to Finnerty by the firm's lawyer, from whom Finnerty sought legal advice about the constraints on insider selling. She and Finnerty met once to discuss his long-range investment goals. He expects to live off of his salary for the forseeable future. He prefers to invest his equity wealth for a future home purchase, as a hedge against the firm folding, and finally for his eventual retirement.
Approach the case from Razi's perspective. Due to the graphic nature of this case, I would like you to make copies of some of your "favorite" figures on to transparencies for the class discussion.
1) Historical Inputs
Construct an efficient frontier using the historical performance of the S&P 500 and the EAFE index.
a) What is the minimum variance portfolio composed of?
b) What is the composition of the portfolio that minimizes the probability of dropping below the current U.S. T-bill rate?
2) Forecasting Inputs
Consider the U.S. economy vs. the global economy.
a) Do you expect there to
be long-term differences in the expected returns of these two indices?
b) If so, why, if not, why not?
c) How could you address this issue with the optimizer?
3) Building a Global Portfolio
Suppose you could invest in the country indices of Japan, United Kingdom, Germany and South Africa. Futher, suppose you criterion for an optimal portfolio was one that minimized the probability of dropping below the current U.S. riskless rate. Using dollar-denominated returns, construct an efficient frontier of the equity indices of these countries.
a) What is the optimal portfolio composed of? b) Now include the S&P 500. How does this change the composition of the optimal portfolio? Is the US/Non-US proportion similar to the optimal mix you found in 1b? Is so, consider the reasons for this.
4) Emerging Markets
How will the portfolio be affected by the introduction of emerging markets? To explore this, select some promising emerging markets from the Ibbotson database, and include them in your optimization problem -- either as additions to the S&P / EAFE mix of question 1, or the mix in question 3.
1) How much better can you do with one or two emerging markets?
2) What percentage of your portfolio do you put into emerging markets?
3) Does this seem to be a reasonable portfolio? Comment.
5) Assets & Liabilities
Often, current holdings, human capital and future liability streams are not consideredin the asset allocation process. Razi wishes to explicitly consider them in her analysis
a) Razi wishs to identify an asset or asset class that is correlated to Finnerty's stock options. What might that be? Can you find something like
this in the EnCorr database?
b) Take the asset class you found (or created!) for 5a, and include it in the optimization problem as an asset you are CONSTRAINED to hold. Determine the proportion by estimating Finnerty's portfolio holdings from the case. Assume Finnerty will sell his 100,000 shares in the brokerage account to purchase other assets. For simplicity, since you don't know the strike price of the remaining options, assume that they effectively behave as stock. How does this affect the optimal asset allocation?
c) How would you include Finnerty's human capital in the optimization?
d) Finnerty plans to stay in the United States for the rest of his life. How can you use the liability "asset" approach to model his long-term liabilities and include them in the optimizer?
What do you recommend to Finnerty as an investment strategy? What instruments, i.e. securities, and or mutual funds would you suggest he use to implement this strategy?