Planning and decision-making associated with the development of a self-managed superannuation

fund (Portfolio Theory and Asset Pricing)

Due to the high management fees and the recent poor return performance associated with
his employer-sponsored superannuation fund, Les Risky has decided to supplement these
savings by starting his own self-managed investment fund. Les considers himself to be
relatively knowledgeable regarding financial markets including the share market and
thinks that he can identify profitable share investments as well as so-called professional
fund managers can. Les plans to start this investment fund with $10,000 of his own
savings and will allocate an additional $100 per week from his salary to expand the
funds holdings and investments.
Les has decided to concentrate on investing in shares listed on the Australian Stock
Exchange (ASX), as he is most familiar with this market, and believes that shares will
provide a higher long-term return than other investments such as property or
infrastructure assets. At the moment he is weighing up two possible investment strategies
to apply to his investment funds. These are:
Directly invest in a portfolio of individual company shares from a variety of industry
sectors, which he plans to personally research and choose.
Indirectly invest in Australian company shares through industry-managed funds (such
as Colonial First State, ING Australia, AXA Australia Investments, Bankers Trust or
Macquarie Managed Investments). These funds normally invest in a diverse portfolio
of shares tracking a particular performance indicator, such as the All Ordinaries Index
or the S&P/ASX 200 index.
As a result of Less disappointment with the performance of his employment-based
superannuation plan, which has a similar profile to the latter above strategy, Les is
favouring the first idea of stock-picking his own personal portfolio of company shares.
After some initial research, Les has narrowed his list of preferred investments to the
following companies:
Company name
National Australia Bank Limited
Coca-Cola Amatil Limited
James Hardie Industries Limited
Lend Lease Corporation Limited
News Corporation Limited
Sons of Gwalia Limited
Westfield Trust Limited
Woodside Petroleum Limited

ASX code
NAB
CCL
HAH
LLC
NCP
SGW
WFT
WPL

Industry sector
Banking and Finance
Food and Household Goods
Building Materials
Developer and Contractor
Media
Gold Mining
Investment Company
Oil and Gas Exploration

Les has intentionally chosen companies from a range of different industry sectors to try
and maximise the potential diversification benefits in forming his investment portfolio,

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and will look to widen the number of companies included in his portfolio as he invests
more funds in the portfolio through his salary contributions.
As part of Less preliminary analysis of desirable company investments, he accessed
historical share price information on the above selected companies and calculated total
return and standard deviation measures for the last financial year from 1/7/00 to 30/6/01,
and beta coefficients for prediction purposes using individual share and market return
data for the previous financial year (from 1/7/99 to 30/6/00):

Company name
National Australia Bank
Coca-Cola Amatil
James Hardie Industries
Lend Lease Corporation
News Corporation
Sons of Gwalia
Westfield Trust
Woodside Petroleum
All Ordinaries Index

Total share return

10.97%
62.78%
9.28%
2.69%
57.90%
27.77%
5.81%
23.96%

Standard
deviation of daily
returns
1.62%
2.73%
2.07%
1.75%
3.42%
2.45%
1.04%
2.08%

Beta coefficient
0.906
0.718
0.626
0.683
2.625
0.349
0.381
0.778

12.28%

0.92%

1.000

Using this daily return information, Les also attempted to determine the relationship
between the daily share-price movements of these companies by calculating their relative
correlation coefficients:

NAB
CCL
HAH
LLC
NCP
SGW
WFT
WPL

NAB
1.000

CCL
0.150
1.000

HAH
0.211
0.253
1.000

LLC
0.176
0.091
0.075
1.000

NCP
0.117
-0.001
0.111
0.118
1.000

SGW
0.163
0.139
0.101
0.184
0.002
1.000

WFT
0.309
0.323
0.200
0.198
0.116
0.124
1.000

WPL
0.187
0.218
0.212
0.109
0.120
0.041
0.176
1.000

Les has found this information useful for evaluation purposes, but due to the short timeframe of the information he is uncertain about its reliability, and the likelihood that
similar share returns will be provided by these companies in future years. He does,
however, accept that he could invest in an index-matched managed fund and earn an
average long-term return similar to that provided by the All Ordinaries Index. Les is also
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concerned about the potential risk exposure associated with a small portfolio of shares
and is looking to minimise the risk of his portfolio as much as possible.
Les is now at the stage of deciding his initial investment choices and structuring his
investment fund, and is looking at answering the following questions. He has asked for
your advice on these matters.
Questions:
1) Traditional risk and return concepts suggest that a positive relationship should exist
between the risk associated with an investment security and the relative return that it
provides to the holders. Review the return and standard deviation information
provided in the first table above, and outline whether Less selected companies
provide results consistent with this expected positive relationship between risk and
return. Specify any companies that appear to violate this relationship and should be
rejected as investment choices by Les. Also, outline whether the concept of portfolio
theory holds in that portfolio risk is minimised by holding a well-diversified
portfolio of shares (such as the All Ordinaries Index portfolio).
2) Les has decided to construct his initial portfolio employing equally-weighted
investments in three of his above-selected company shares. Using the above
information, recommend to Les the three company shares that he should invest in,
taking account of his desire for a portfolio return at least equivalent to that of an
index-matched fund while also minimising his risk exposure. Using the historical
information provided for the 2001 financial year, calculate the actual return and
standard deviation of this portfolio. Does it outperform the performance of the
market-wide All Ordinaries Index over this period?
3) As a check on his company selections, Les would like to review the performance of
his chosen companies, over this period, against a well-respected asset pricing model.
Apply the capital asset pricing model (CAPM) equation, using the above provided
data, to predict the expected returns of these shares for the 2001 financial year (Note:
the average return on 90-day bank bills was 5.20 per cent over this period). Compare
the companies actual return performance with that expected by the CAPM, and
outline what these results suggest about the accuracy of the CAPM as a returnestimating model. Do your portfolio selections agree with the results of this CAPM
evaluation?

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