Pravda Asset Management

This case examines the importance of forecasting expected returns in asset allocation decisions. Although the case is targeted to MBA students in an investments or portfolio management course, it is also appropriate for an advanced undergraduate course. It is written from the perspective of a new employee at a small investment management firm that was surprised by the market crash of 2008 and subsequent market rebound in 2009. Students must analyze the ability of simple valuation ratios to forecast returns and will use a smoothed price-to-earnings ratio to forecast future returns. In addition, students must use their regression results to form a simple (two-asset) tactical asset-allocation strategy to better understand the importance of forecasting expected returns for asset-allocation decisions and how such forecasts could be used to form a simple tactical asset-allocation model. Excerpt UVA-F-1602 Rev. Feb. 10, 2015 Pravda Asset Management When Lucy Cowley took her job with Pravda Asset Management (Pravda) after graduating in May 2007, she had not imagined her first few years in the investment industry would be so turbulent. She could only take solace in the fact that she was not alone in her situation. The market decline of 2008 and the market volatility of 2009 had clearly taken many in the investment industry by surprise. Across the spectrum of investment firms, from small-scale retail brokerage to large-scale institutional asset management, clients were furious at investment managers' inability to predict these market swings. In hindsight, the crash of 2008, rooted in cheap credit and the associated housing bubble, seemed obvious to many of these investors. Cowley's firm specialized in endowment and foundation management. Although it was a small operation with just 14 employees, it was unique in its ability to offer full-scale asset management services. From a suggested policy portfolio and the associated target and tactical asset-allocation decisions to manager selection and all of the back-office functions in between, Pravda handled all investment functions for its clients. Cowley worked with CIO Bernard Alexander, who oversaw asset allocation for Pravda. Following the approximately 40% decline in the market in 2008 (Exhibit 1), Alexander had become skeptical about a quick market rebound. He had encouraged clients not to rush back into equities, and for the first two months of 2009, his advice seemed prescient. Unfortunately, since that time the market had rebounded to pre-2009 levels, leaving Pravda's clients even more frustrated. . . .