MGFB10H3 Principles of Finance

Assignment 2
Investments
Problem 1 You graduated and your job search led you to your dream job. Yay! The first
day on the job, while you are finishing your employment paperwork, Emma Li, who works in
Finance, stops by to inform you about the company’s retirement plan. Retirement plans are
offered by many companies and are tax-deferred savings vehicles, meaning that any deposits
you make into the plan are deducted from your current pre-tax income, so no current taxes
are paid on the money. For example, assume your salary will be $100,000 per year. If you
contribute $6,000, you will pay taxes on only $94,000 in income. There are also no taxes
paid on any capital gains or income while you are invested in the plan, but you do pay taxes
when you withdraw money at retirement.
Your company uses TD Financial Services as its plan administrator. The plan has several
options for investments, most of which are mutual funds. A mutual fund is a portfolio of
assets. The return of the fund is the weighted average of the return of the assets owned by
the fund, minus any expenses. The largest expense is typically the management fee, paid to
the fund manager. The management fee is compensation for the manager, who makes all the
investment decisions for the fund. Here are the investment options offered for employees.

• Company Stock. One option is stock in the company you now work for. The company is
currently privately held. However, during the interview, you learned that the company
stock was expected to go public via an IPO process in the next three to four years.

• TD TSX Composite Index Fund. This is a passive mutual fund that tracks the TSX
Composite. Stocks in the fund are weighted exactly the same as the TSX Composite
index. This means that the fund return is approximately the return on the TSX,
minus expenses. Because an index fund purchases assets based on the composition of
the index it is following, the fund manager is not required to research stocks and make
investment decisions. The result is that the find expenses are usually low. The TD
TSX Composite Index Fund charges expenses of 0.15 percent per year.

• TD Small-Cap Fund. This fund primarily invests in small-cap stocks. As such, the
returns of the fund are more volatile. The fund can also invest 10 percent of its assets
in companies based outside Canada. This fund charges 1.70 percent in expenses.

• TD Large-Company Stock Fund. This fund invests primarily in large-cap stocks of com-
panies based in North America. The fund is actively managed and has outperformed
the market in six of the last eight years. The fund charged 1.50 percent in expenses.

• TD Bond Fund. This fund invests in long-term corporate bonds issued by Canadian-
domiciled companies. The fund is restricted to investments in bonds with an investment-
grade credit rating. This fund charged 1.40 percent in expenses.

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 The standard deviation and average return of the funds over the past 10 years:
10-year average return Standard deviation
TD TSX Composite Index Fund 9.18% 20.43%
TD Small-Cap Fund 14.12% 25.13%
TD Large-Company Stock Fund 8.58% 23.82%
TD Bond Fund 5.45% 9.85%
1. Assume you decide to invest at least part of your money in large-cap stocks of compa-
nies based in North America. What are the advantages and disadvantages of choosing
the TD Large-Company Stock Fund compared to the TD Composite Index Fund.
2. The returns on the TD Small-Cap Fund are the most volatile of all the mutual funds.
Why would you ever want to invest in this fund? When you examine the expenses of
the mutual funds, you will notice that this fund also has the highest expenses. Does
this affect your decision to invest in this fund?
3. What advantages do the mutual funds offer compared to the company stock? A friend
told you that you should also look into the exchange traded funds (ETFs). What is
an ETF? What is the difference between ETFs and mutual funds?
Problem 2 You are discussing your retirement plan with Emma Li when she mentions
that Maureen O’Brien, a representative from TD Financial Services, is visiting your office
today. You decide that you should meet with Maureen, so Emma sets up an appointment for
you later in the day. When you sit down with Maureen, she discusses the various investment
options available in the company’s retirement plan. You mention to Maureen that you
researched your new employer before you accepted your new job. Analysis of the company
has led to your belief that the company is growing and will achieve a grater market share
in the future. You also feel you should support your employer. Given these considerations,
along with the fact that you are a conservative investor, you are leaning toward investing
100% of your retirement amount in the company you now work for.
Assume the risk-free rate is the historical average T-Bill rate of 3.4%. The correlation
between the TD Large-Cap Stock Fund and the TD Bond Fund is 0.15. Note that the
spreadsheet graphing and “Solver” in Excel may assist you in answering the questions.
1. How should Maureen respond to the suggestion that you invest 100 percent of your
retirement savings in the company you now work for? What about when you say that
you are a conservative investor and that a 100 percent investment in the bond fund
may be the best alternative. Is it?
2. Using the average returns and standard deviations for the TD Large-Cap Stock Fund
and the TD Bond Fund (see the table in Problem 1), graph the opportunity set of
feasible portfolios you can form from these two risky assets. Examining the opportunity
set, notice there is a portfolio that has the lowest standard deviation. What are the
portfolio weights, expected return, and standard deviation of this minimum variance
portfolio? Why is the minimum variance portfolio important?

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3. What are the portfolio weights, expected return, and standard deviation of the tan-
gency portfolio? Using this information graph the capital allocation line alongside the
opportunity set of risky assets. How does the Sharpe ratio of the tangency portfolio
compare to the Sharpe ratios of the bond fund and the large-cap stock fund?

4. Compute an efficient portfolio of both risky funds and a risk-free asset that would be
preferred by an investor that has a low volatility (risk) target of σ(RP ) = 5%. What is
the optimal portfolio for this investor? What about a more risk tolerant investor who
has a high expected return target of E(RP ) = 12%. What is the optimal portfolio for
this other investor? Report the composition, the expected return, and the volatility of
these two portfolios. Comment on the ratio of investment in the TD Large-Cap Stock
Fund and the TD Bond Fund for both investors.

5. (Bonus question) Would some other investors who are considering investing in the TD
Large-Cap Stock Fund, the TD Bond Fund, and the risk-free asset find it efficient to
short sell one of the two funds? Explain.