The process of constructing an investment portfolio is critical in determining the success with which an investor creates wealth. An effective investment portfolio should be comprised of different types of securities. The rationale of including different securities is to improve the degree of diversification hence improving the likelihood of cautioning the investor against risk. Rittereier and Kochard (2013) argue that investors should hedge and diversify against risk. Therefore, investors should have adequate understanding on the characteristics of different securities prior to selecting the components of the investment portfolio. In this case, rationale to select the GuideStone Funds Extended-Duration Bond Fund (GEDYX), iShares Core Long-Term U.S. Bond, and the Royal Dutch Shell Bond as the key components of the investment portfolio is based on a number of aspects.
The first aspect relates to risk. The three securities are characterized by a considerably low degree of risk and a high rate of return. Therefore, the choice of the three securities is informed by the extent to which the securities shield the investor from economic occurrences such as inflation. The high rate of return associated with the three securities increases the probability of the investor generating high wealth. Despite the existence of market fluctuations, the three stocks have been characterized by a considerably high rate of return with regard to stability. Therefore, the three stocks provide the investors a high degree of safety and security.
The objective of this paper is to assess the appropriateness of including the three securities in the investment portfolio. The paper focuses on the securities weights, the performance of the portfolio based on the Sharpe measure, Jensen measure and the Treynor measure.
According to Rittereiser and Kochard (2013), it is imperative for the investor to quantify the risk. The quantification of the risk improves the efficiency with which the investor undertakes the portfolio construction process hence increases the portfolio’s capacity to withstand unforeseen risks. One of the most effective ways of quantifying the risk entails determining the portfolio’s weight. An investment’s portfolio weight represents the proportion of the investment’s total value that is associated with the specific asset. It is essential for investors to determine the weight of the security that he or she intends to include in the portfolio. The weight of the portfolio provides investor insight on the expected future returns and risk.
The weights of the respective investments are illustrated in the following scenario. In this case, the three investments include GuideStone Funds Extended-Duration Bond Fund (GEDYX), iShares Core Long-Term U.S. Bond ETF (ILTB) and the Royal Dutch Shell Bond. The assumption is that the investor intends to hold100, 120 and 150 units of the three investments respectively. The three investments are characterized by varying share price. The share price for the RDSB bond is $43.89 while that of the GEDYX and iShare includes $ 3.81 and $ 59.76 respectively. Based on this information, the three weights of the three investments can be determined by following the following steps.
Step 1: Determination of the respective investments total value
The total value is calculated by multiplying the number of units with the stock price.
- Royal Dutch Shell Bond; $43.89×150 units=$ 6,583.50
- GuideStone Funds Extended-Duration Bond Fund (GEDYX); $ 3.81×100 units=$381
- iShares Core Long-Term U.S. Bond ETF (ILTB); $ 59.76×120 units=$ 7,171.20
Step 2: Calculation of the portfolio’s total value
This step involves summation of the respective total value of the different components of the portfolio. In this case, the portfolio’s total value is determined by adding the values of $ 6,583.50, $381 and $ 7,171.20, which amounts to $14,135.70.
Step 3: Individual weights
The weights of the individual assets can be determined by dividing the portfolio’s total value by the respective investment value as illustrated below.
- Royal Dutch Shell Bond; $ 6,583.50÷$14,135.70=0.47
- GuideStone Funds Extended-Duration Bond Fund (GEDYX); $381÷ $14,135.70=0.03
- iShares Core Long-Term U.S. Bond ETF (ILTB); $ 7,171.20÷$14,135.70=0.51
The analysis shows that the weights of the Royal Dutch Shell Bond, GuideStone Funds Extended-Duration Bond Fund (GEDYX) and iShares Core Long-Term U.S. Bond ETF (ILTB) include 0.47, 0.03 and 0.51 respectively. The decision to include the respective investments in the portfolio is based on the summation of the respective invests, viz. [0.47+0.03 + 0.51] which amounts to 1.01. The total value of the weights of the three investments is greater than 1, which indicates a positive return. The weights of the three investments can be expressed as a percentage, which translates to 47%, 3% and 51%. Based on the respective weights, including the three securities in the portfolio will enable the investor to attain the intended wealth maximization objective.
Portfolio performance measure
The core purpose of constructing a portfolio is to generate high returns with reference to capital gains and current income. The current income refers to the interest payments and dividends on the respective bonds. Conversely, capital gains or losses are determined by calculating the difference between the security’s sale price and purchase price. Investors should assess the portfolio returns by evaluating the performance of the respective securities. Investors can achieve this goal by taking into account three main measures that include the Sharpe measure, Treynor measure and the Jensen measure.
This measure is determined by dividing the risk premium by the portfolio’s standard deviation as illustrated by the formula below.
Sharpe Measure = Risk Premium
The risk premium entails the difference between the total portfolio return and the risk free rate. The three securities are characterized by varying rates of return, and standard deviation. However, the risk free rate is assumed constant across the three securities as illustrated in the table below.
|RDSB Share Price||GuideStone Funds Extended-Duration Bond Fund (GEDYX)||iShares Core Long-Term U.S. Bond|
|Rate of return (%)||6.51%||6.58%||6.56%|
|Risk free rate (%)||2%||2%||2%|
|Risk premium (%)||4.51%||4.58%||4.56%|
|Standard deviation (%)||7.81%||8.39%||5.93%|
A comparison of the three funds shows that they are characterized by a relatively high Sharpe ratio, which denotes a considerably high rate of return. However, the iShare fund is characterized by a considerably high return compared to the other funds. Therefore, the investor will benefit significantly due to their risk taking characteristic.
The motive of this measure is to compare the risk premium of a portfolio with its systematic risk. The Treynor ratio is calculated using the formula below.
Treynor Ratio = Risk Premium
The chart below illustrates the risk premium and portfolio beta of the respective three components of the investment portfolio.
|RDSB Share Price||GuideStone Funds Extended-Duration Bond Fund (GEDYX)||iShares Core Long-Term U.S. Bond|
|Risk premium (%)||4.51||4.58||4.56|
The Treynor measure shows that the three funds are characterized by a positive ration. This indicates that the investor will generate positive returns by including the three funds in the portfolio. This move will lead to generation of a better risk-adjusted return. One of the characteristics that make the funds attractive for inclusion in the portfolio relates to the low value of beta amongst the three funds. Subsequently, the degree of volatility of the three funds to market changes is considerably low.
The appropriateness of the three funds in the portfolio is further supported by the outcome of the Jensen measure as evaluated herein. The Jensen measure provides investors an opportunity to assess the risk associated with a particular investment portfolio. Based on the Jensen measure, the investor’s capacity to make a rational decision on whether it is worth to take the risk associated with a particular investment based on the returns generated (Fiebel, 2007). The Jensen measure or the Jensen alpha is calculated using the formula below.
Jensen Measure= Portfolio return- Risk-free rate-[Beta × (market return-Risk-free rate)]
It is assumed that the market return is 3%. Based on this assumption, the Jensen’s alpha of the respective funds can be calculated as below.
- RDSB Share Price
Jensen Alpha= 6.51%-2%-[2.52× (3%-2%)] = 3.99%
- GuideStone Funds Extended-Duration Bond Fund (GEDYX)
Jensen Alpha=6.58%-2%-[2.56× (3%-2%)] =2.02%
- iShares Core Long-Term U.S. Bond
Jensen Alpha=6.56%-2%-[2.56× (3%-2%)] =2%
The three returns are characterized by the same rate of market return but varying values of beta. The Jensen value of the three funds is positive which indicates a positive return. Analysts postulate that if the value of Alpha of a particular investment is greater than zero, then it has a higher return. A positive value of Alpha indicates that the return of the three funds is above the capital market line. Moreover, “a large Jensen’s Alpha indicates excess returns after controlling for the market sensitivity [beta] of the portfolio” (Feibel, 2007, p. 196). Subsequently, the investor is likely to create substantial wealth by investing in the three funds.
Analysis on the performance of the investments
The three investments have portrayed a considerably strong performance over the past years. The table 1 and graph 1 illustrates the growth of a $10,000 GuideStone Funds Extended-Duration Bond Fund (GEDYX).
Despite the fluctuation in the funds growth experienced in 2013 and 2015, the fund fund has potrayed a relatively high rate of growth over the past five years. Similary, the Royal Dutch Shell Bond depicts a strong performance as illustrated by table 4 and graph 2 below.
Graph 2 shows that the Royal Dutch Shell Bond is characterised by a relatively positive performance. Despite, the decline in the rate of growth experienced in 2012, 204 and 2015, the Royal Dutch Shell Bond might experience strong rate of growth in the future. The decline in performance might have arisen from economic fluctuations. Similarly, graph 3 shows that the iShare investment has experienced a strong performance despite the recent fluctuations experienced.
Soundness of the portfolio
The inclusion of the three securities in the investment portfolio increases the soundness of the portfolio. One of the factors that contributes to the effectiveness of the portfolio in generating wealth relates to efficient asset allocation. In this case, the proportion of investment in the respective securities varies significantly. Therefore, one can argue that the investor has taken into account strategic and tactical asset allocation. Darst (2008) asserts, “tactical alocation enable investors to anticipate and respond to significant shift in asset prices while strategic allocation allows investors to map out a long-term plan for eploying asset to attain multiyear or even multidecade goals” (p.31). Subsequently, the portoflio is effective in cautioning the investor against market changes.
In addition to effective allocation allocation, the analysis shows that the three portfolios are characterised by a positive rate of return. One of the aspects that depict the positive rate of return relates to the respective weights of the three investments that include 47%, 3% and 51%. Therefore, inclusion of the three securities will increase the likelihood of the investor generating high returns. The effectiveness of the respective securities in generating high returns is associated with the fact that competent fund managers manage the funds. To generate returns, the fund managers ensure that the fund generates returns from different types of investments. Examples of such investments include swap contracts, futures, options and cash equivalents. Consequently, the respective investments are very effective in generating returns.
The analysis indicates that the three securities are viable for inclusion in the investment portfolio. Inclusion of the three securities in constructing the intended investment portfolio will improve the investor’s capacity to generate wealth. This arises from the distinct characteristics of the three securities. First, the total weight of the three securities is greater than 1, which indicates that the investor is likely to generate positive returns from the investment. Secondly, an analysis of the three securities based on the Sharpe measure, Jensen measure and the Treynor measure indicates that the securities are less volatile to market changes. An assessment on the degree of risk and the rate of return is in the process of constructing an investment portfolio. This arises from the fact that the investor gains insight on how to allocate the investment. For example, the investor is able to assess whether the investment is aligned with the principle of high-risk-high-return.
In addition to the above aspects, the viability of investing in the three portfolios in generating wealth is underlined by the performance of the three securities over time. Despite the fluctuation in the performance of the securities over the past few years, the three securities have depicted a high probability for future growth. Subsequently, the portfolio is likely to promote the investors capacity to generate sustainable returns in the future. In spite of the attractiveness associated with inclusion of the three securities in the portfolio, it is imperative for the investor to evaluate the performance of the individual securities. This issue arises from the fact that the characteristics of the respective securities are subject to change due to diverse market factors. Undertaking continuous evaluation of the portfolio will provide the investor insight on how to adjust the investment portfolio.
Darst, D. (2008). The art of asset allocation: principles and investment strategies for any market. New York, NY: McGraw-Hill.
Feibel, B. (2007). Investment performance measurement. Hoboken, NJ: Wiley.
Market Watch. (2015). GuideStone Extended-Duration Bond Fund. Web.
Morning Star. (2015a). Royal Dutch Shell PLC Bond. Web.
Morning Star. (2015b). iShares core 10+ year USD bond ETF. Web.
Rittereiser, C., & Kochard, L. (2013). Top hedge fund investors; stories, strategies and advice. Hoboken, NJ: Wiley.