Assume that there is NO exchange rate risk. You are managing an equity MPF in Hong Kong and wonder about your global asset allocation. You believe that foreign markets will outperform HK, but nothing is sure. You do a mean variance optimization and find that you should allocate 80% abroad. You know that the theory of the CAPM tells you to allocate according to market capitalization weights; hence you should invest more than 95% in non-Hong Kong equity. On the other hand you observed the standard of MPF in Hong Kong is only to invest 40% abroad (average over all equity MPFs).
Note, that there is no RIGHT answer. Please consider that you are writing a short memo to your investment committee.
a. In the absence of specific expectations about returns in Hong Kong or abroad, what would regret theory suggest as global asset allocation?
b. Given all the information above, what will you choose as a percentage of asset allocation and why?
c. You decide to forget about regret and simply try to obtain the best risk-adjusted return.
Actually your own expectation is quite bullish about China and Hong Kong but you know that any forecast is uncertain. But you expect Hong Kong to outperform the rest of the world by some 2% (12% instead of 10%). Hong Kong sigma is 20% while that of the MSCI World index (excluding Hong Kong) is only 15% with a correlation of 0.5. You desire that the volatility (sigma) of your portfolio be no more than 15%. How would you determine the optimal allocation between HK and the rest of the world?