Let us look at some theoretical concepts first : The mean variance framework, determines the optimal allocation to different asset classes that minimizes portfolio return variance. This is done by plotting allocations to the various asset classes across two axes representing risk and return. When the CAPM assumptions hold, an optimal portfolio is a combination of the risk-free investment and the market portfolio. This line is obtained by plotting a point representing the riskfree return on the y-axis and drawing a tangent to the efficiency frontier we obtain a line called the capital market line (CML) which represents the most efficient portfolio allocation.
Extending this theory to the HMC case, it appears that TIPS has been considered as a risk free security by HMC and added to the efficiency frontier (which was obtained as a result of the various portfolio simulations using mean variance analysis). This completed the Capital Market line and enabled HMC to come up with recommendations for the most efficient portfolio given the available asset classes.
We would agree with this allocation by HMC to TIPS in order to introduce an element of real risk free return in the portfolio. This is on the anticipation that the US economy would be subject to inflationary pressures in the near future. Here is why : We believe that the world has benefited in the last few years from two major dis-inflationary forces that will likely diminish in importance going forward: • increased U.S. productivity and
• the entry of low cost workers in the “global workforce”, particularly in China and India. As these forces diminish, inflationary pressures will pick up, making securities such as TIPs (Treasury Inflation-Protected securities) a good addition to endowment portfolios.