3) Portfolio Optimization (21 points) Hennessy & Associates manages a $30 million equity portfolio for the multimanager Wilstead Pension Fund. Jason Jones, financial vice president of Wilstead, noted that Hennessy had rather consistently achieved the best record among the Wilstead's six equity managers. Performance of the Hennessy portfolio had been clearly superior to that of the S&P500 in four of past five years. In the one less-favorable year, the shortfall is trivial. Hennessy is a "bottom-up" manager. The firm largely avoids any attempt to "time the market". It also focuses on selection of individual stocks, rather than the weighting of favored industries. There is no apparent conformity of style among the six equity managers. The five managers, other than Hennessy, manage portfolios aggregating $250 million made up of more than 150 individual issues. Jones is convinced that Hennessy & Associates is able to apply superior stock selection, but the favorable returns are limited by the high degree of diversification in the portfolio. Over the years, the portfolio generally held 40-50 stocks, with about 2%-3% of total funds committed to each issue. The reason Hennessy seemed to do well most years was because the firm was able to identify each year 10-12 issues which registered particularly large gains. Based on this overview, Jones outlined the following plan to the pension committee: Let'stell Hennessy to limit the portfolio to no more than 20 stocks. Hennessy will double the commitments to stocks that it really favors, and eliminate the remainder. Except for this one new restriction, Hennessy should be free to manage the portfolio exactly as before. All the members of the pension committee generally supported Jones' proposal because all agreed that Hennessy had seemed to demonstrate superior skill in selecting stocks. Yet the proposal was a considerable departure from previous practice, and several committee members raised questions. Respond to each of the following questions. a. Will the limitations of 20 stocks likely increase or decrease the risk of the portfolio? Is there any way Hennessy could reduce the number of issues from 40 to 20 without significantly affecting risk? (7 points) 3) Portfolio Optimization (21 points) Hennessy & Associates manages a $30 million equity portfolio for the multimanager Wilstead Pension Fund. Jason Jones, financial vice president of Wilstead, noted that Hennessy had rather consistently achieved the best record among the Wilstead's six equity managers. Performance of the Hennessy portfolio had been clearly superior to that of the S&P500 in four of past five years. In the one less-favorable year, the shortfall is trivial. Hennessy is a "bottom-up" manager. The firm largely avoids any attempt to "time the market". It also focuses on selection of individual stocks, rather than the weighting of favored industries. There is no apparent conformity of style among the six equity managers. The five managers, other than Hennessy, manage portfolios aggregating $250 million made up of more than 150 individual issues. Jones is convinced that Hennessy & Associates is able to apply superior stock selection, but the favorable returns are limited by the high degree of diversification in the portfolio. Over the years, the portfolio generally held 40-50 stocks, with about 2%-3% of total funds committed to each issue. The reason Hennessy seemed to do well most years was because the firm was able to identify each year 10-12 issues which registered particularly large gains. Based on this overview, Jones outlined the following plan to the pension committee: Let'stell Hennessy to limit the portfolio to no more than 20 stocks. Hennessy will double the commitments to stocks that it really favors, and eliminate the remainder. Except for this one new restriction, Hennessy should be free to manage the portfolio exactly as before. All the members of the pension committee generally supported Jones' proposal because all agreed that Hennessy had seemed to demonstrate superior skill in selecting stocks. Yet the proposal was a considerable departure from previous practice, and several committee members raised questions. Respond to each of the following questions. a. Will the limitations of 20 stocks likely increase or decrease the risk of the portfolio? Is there any way Hennessy could reduce the number of issues from 40 to 20 without significantly affecting risk? (7 points)