Harvard Management Company

1453 Words6 Pages
Frame the issue. Discuss the advantages and limitations of optimal portfolio allocation. HMC defined their Policy Portfolio to correspond to their benchmark, according to the modern portfolio theory (Markowitz, 1952), whose goal is to minimize the variance for a given return. The main advantage of the optimal portfolio allocation lies in its ability to provide weights on how to invest a given amount of money based on a few inputs. Optimal portfolio allocation is easy to implement, yet it faces some issues and limitations. As discussed in class, the model assumes normality in the returns, since the optimization only depends on the mean and the variance. HMC team should however take into account that the distribution of returns is not…show more content…
The efficient portfolios suggest not invest in any equity. Moreover, the expected return of the portfolio is increasing in the emerging market/private equity/commodities’ weight. As we mentioned above, the optimal asset allocation includes non-traditional position and this is why HMC imposed some constraints on the asset classes. According to Exhibit 12 and given that the required return should be around 4.5% - 7.5% per year to cover the endowment distribution need [historical endowment spending shown in Exhibit 1 (3.5% - 4.5%) + the inflation rate (1% - 3%) + real growth of the fund], HMC knows its investment optimal policy. Exhibit 13 gives more traditional weights by imposing some constraints on the optimizer, in order to make Harvard look alike its competitors (the others universities). Discuss the pros and cons of constraining portfolio weights. Adding constraints to the portfolio makes the model more realistic in one hand, because it suits better with the firm’s benchmark and the firm’s possibilities; but in the other hand, achieving the same return will imply more risk-taking as well. The efficient frontier moves to the right. Asset class may indeed have different transaction costs and, as long as the model does not take transaction costs into account, HMC has to constraint the model to minimize these costs. Another reason to constraint the model is the difference in the taxation of the money invested in different classes of assets. Finally, constraining the
Get Access