Reading 26, Example 5 Adding real estate to SAA

CFA Level III Portfolio Management
#1

Hey guys I have a stupid question:

There is a foundation with SAA 50/50. 12% of the common stock allocation (6% of total portfolio) is in REITs

The Risk free rate is 2.5%

Forecasted inflation rate is 2%

Foundation’s investment objective is to preserve real value of assets after spending. It’s spending rate is 5% of 12 month average asset value.

The foundation’s cost of earning returns is 20 basis points a year.

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I’m trying to get the required return:

The curriculum has it as 1.02 (Forecasted inflation rate) * 1.05 (spending rate) * 1.002 (management fee) = 7.31%

I would have added the risk free rate too. Since we are trying to preserve our real value of the assets , don’t we need to take the nominal interest rate in our spending requirement i.e either 1.045 or (1.02 * 1.025) = 9.99 or 10%?

#2

No, by convention, we accept that preserve the real value of the assets means preserve the real value of the assets from inflation. And so the foundation must generate a return (in $) to cover

  • spending 5% * V
  • management fee 0.2% * V
  • value generated from inflation rate: 2% *V
#3

pierre is spot on, risk-free rate is not part of return objective. it’s there to confuse you.

#4

Yep. Magician put it well in one of the threads. If John has $100 today and inflation is 2% and he wants to have $100 next year in today’s dollars (I.e. real value) his return requirement is 2%, not 0%. Next year he needs $102 dollars to be the equivalent of $100 today.

#5

Why are the returns geometrically linked and not just added together?

Ex. 5% + 2% + 0.2% = 7.2%

#6

geometric linking is more appropriate. however, for the purpose of the exam, both arithmetic addition and geometric multiplication are allowed.

#7

Thank you…so when you are calculating a return requirement, is there any situation where you would include the risk free rate?