Asset Allocation, Book 3 Page 263 Solution to 2.

The solution is :

Despite the fact that EX UK equities have the second highest standard deviation of return (18 Percent), ex-UK equities appear with substantial weight in the efficient portfolio that has the smallest standard deviation of return, the GMV portfolio, as well as in other expected low risk, efficient portfolios. Thus Ex us equities appear to be an effective risk diversifier.

  1. What are they calling the “GMV” portfolio? Portfolio 8? It has the smallest STDev.

  2. Substantial weight? 8.34% in portfolio 8? That is substantial?

  3. The correlation is .76 of ex UK equities to UK…That is effective diversification?

I expected the answer to be it isn’t a very effective diversifier, compared to other asset classes, given its high correlation. Any comments on this?

Portfolio 8 is the Global Minimum Varinace portfolio and all they are trying to say is that despite Ex-UK equities standalone standard deviation being on the larger side (18%) (2nd largest out of the lot), when added to efficient corner protfolio even with a 8.34% weightage, the overall standard deviation of the GMV still remains the lowest! So we have to understand that very little shade of grey, in interpreting that, the only way possible to do so was when Ex UK equities act an an catalyst in driving down the overall STD, by providing diversification benefits.

Than being said, I definitely hear you, it’s difficult to undestand what CFAI wants out of the “open ended” questions like this one.

IMO, the point to remember is all asset classes falling under Global Min Variance could act as a risk diversifier. It could also have been international bond or real estate. These are the assets falling under appropriate SAA for client & also under GMV.