ALEX SHARPES PORTFOLIO

On Friday, January 26 2007, Alex Sharpe set in her home office and pondered her investment strategy. During her MBA program, Sharpe had learned that in efficient market, investors should buy and hold the market portfolio because no other portfolio offers that same expected return at a lower risk. Since the Standards & Poors (S&P) 500 was the most commonly used benchmark for the overall U.S. stock market, Sharpe had invested her childrens educational savings in the Vanguard 500 Index Fund, a no-load mutual fund constructed to track the performance of the S&P 500. The S&P 500 index consists of 500 stock chosen for market size, liquidity, industry grouping, among other factors. The index is intended to reflect the risk/return characteristics of large-cap stock. The S&P 500 is a market value-weighted index, i.e. each stocks weight in the index is proportionate to its market value. There are a number of financial products available to investors that are based on the S&P 500 including Vanguards. Investors chose these index funds in order to provide themselves with a broad market exposure without buying 500 different stocks.

Indexing represents a form of passive fund management that offers a low management expense ratio and has historically outperformed most actively managed mutual funds. Vanguard is one of the worlds largest equity and fixed income managers, and had been credited with the popularization of index funds and with the driving down of costs across the mutual fund industry. Vanguard is unique in that it is owned by the funds themselves, which better align managements interests with those of the shareholders. In contrast, other mutual funds have to balance the goals of providing a profit for their outside owners with that of providing the most cost-effective funds for their shareholders.

In order to achieve higher returns, Sharpe has been considering changing her passive investment strategy to one that was more active. She wanted to begin conservatively by adding carefully chosen stocks to her current equity portfolio. Based on recent analyst forecasts, Ms. Sharpe has narrowed her search to the following two companies:

Hasbro (NYSE: HAS) was an American toy and game company that was the second largest toy maker in the world, next to Mattel. Industry sources expected Hasbro to introduce several innovative toys linked to summer 2007 blockbusters, such as Spiderman 3 and the Fantastic Four: Rise of the Silver Surfer. Additionally, Hasbros full length, live action movie based on the companys enormously popular TRANSFORMERS and produced by Tom DeSanto (X-men and X2: X-men United) were scheduled to open in summer 2007.

R. J. Reynolds Tobacco Company (RJR) was the second largest tobacco firm in the world, with a share of approximately 30 percent of the U.S. cigarette market. R.J. Reynolds was a wholly owned subsidiary of Reynolds American Inc. (NYSE: RAI). The company faced some unique challenges: for example, most consumer-product companies did not have to spend millions of dollars annually on advertising aimed at discouraging use of their products for consumers under the age of 18. R.J. Reynolds had been subject to significant litigation for many decades, but the company had a strong track record in defending tobacco-related cases in court and assured its shareholders that it would continue to take appropriate steps to maintain a successful litigation record.

Risk and Return The last five years worth of monthly returns for Vanguard 500 Index Fund, Hasbro, and R.J. Reynolds are provided in exhibit 1. In addition to comparing the returns on the individual components of her portfolio, Sharpe also wanted to fully compare the risk profile of the two companies to that of the Vanguard Fund. She wanted to ensure that the expected return of her new portfolio would provide adequate compensation for taking on any new risky assets.

Date S&P 500 REYNOLDS HASBRO Jan-02 -1,70% 6,13% 1,66% feb-02 -2,31% 9,87% -13,27% mar-02 4,37% -1,37% 10,55%

apr-02 -5,06% 6,87% 1,01% mag-02 -1,19% 2,17% -4,26% giu-02 -7,15% -23,97% -11,37% lug-02 -8,23% 1,64% -9,66% ago-02 0,64% 7,71% 7,35% set-02 -10,14% -31,48% -15,36% ott-02 7,35% 0,57% -8,18% nov-02 5,96% -4,81% 25,44% dic-02 -5,50% 9,09% -9,91% gen-03 -2,46% 0,59% 3,90% feb-03 -1,72% -5,78% 0,92% mar-03 0,89% -19,17% 14,70% apr-03 8,12% -12,68% 15,19% mag-03 6,18% 21,02% 0,06% giu-03 1,48% 9,15% 9,24% lug-03 2,18% -4,54% 7,78% ago-03 2,34% -3,86% -1,86% set-03 -1,06% 15,78% 0,97% ott-03 5,89% 21,47% 16,70% nov-03 1,51% 14,93% 1,42% dic-03 4,39% 5,34% -3,75% gen-04 2,20% 1,56% -7,19% feb-04 1,40% 4,52% 10,73% mar-04 -1,20% -1,99% -0,55% apr-04 -2,56% 7,06% -13,15% mag-04 1,24% -13,23% 4,08% giu-04 2,00% 20,27% -3,36% lug-04 -3,88% 6,45% -4,37% ago-04 0,11% 4,93% 1,98% set-04 1,91% -9,88% 1,46% ott-04 1,66% 1,21% -5,90% nov-04 4,43% 9,83% 7,57% dic-04 3,34% 3,93% 1,84% gen-05 -2,74% 2,32% 1,14% feb-05 2,09% 1,90% 7,76% mar-05 -1,86% -1,66% -3,17% apr-05 -2,66% -3,25% -7,48% mag-05 3,59% 6,34% 6,66% giu-05 0,99% -4,96% 3,02% lug-05 4,22% 5,72% 5,53% ago-05 -0,78% 0,76% -5,65% set-05 0,93% -1,10% -5,07% ott-05 -2,19% 2,38% -4,12% nov-05 3,82% 4,73% 8,39% dic-05 0,19% 7,09% -1,18% gen-06 3,90% 6,08% 5,05% feb-06 -0,36% 4,96% -4,29% mar-06 1,76% -0,61% 3,99% apr-06 1,15% 3,93% -6,59% mag-06 -3,30% 0,26% -5,94% giu-06 -0,19% 4,88% -2,32% lug-06 -0,28% 9,96% 3,26% ago-06 2,30% 2,65% 8,56% set-06 1,81% -4,76% 12,07% ott-06 3,60% 1,92% 13,93% nov-06 2,13% 1,71% 3,20% dic-06 0,91% 1,91% 1,87%

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