A portfolio manager is constructing a new balanced fund and is considering adding a new asset class. This asset class has a high expected return but also a high stand-alone standard deviation. However, its returns have historically shown a negative correlation with the fund's existing equity holdings. From a portfolio perspective, how would adding this asset class likely impact the overall fund's risk and return profile?

Question: A portfolio manager is constructing a new balanced fund and is considering adding a new asset class. This asset class has a high expected return but also a high stand-alone standard deviation. However, its returns have historically shown a negative correlation with the fund's existing equity holdings. From a portfolio perspective, how would adding this asset class likely impact the overall fund's risk and return profile?

Answer options:

• It would likely increase both the overall portfolio's expected return and its standard deviation. ✅ It would likely increase the overall portfolio's expected return while potentially decreasing its overall standard deviation.
• It would likely decrease both the overall portfolio's expected return and its standard deviation.
• It would likely decrease the overall portfolio's expected return while increasing its overall standard deviation.

Correct answer: It would likely increase the overall portfolio's expected return while potentially decreasing its overall standard deviation.

Explanation: Adding an asset class with a high expected return will increase the portfolio's expected return. When an asset has a negative correlation with existing holdings, it means they tend to move in opposite directions, which can significantly reduce the overall portfolio's standard deviation (risk) through diversification benefits, even if the new asset is volatile on its own.