FinQuiz smart summary, asset allocation

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2013, Study Session # 8, Reading # 21

“ASSET ALLOCATION”
SAA = Strategic Asset Allocation
TAA = Tactical Asset Allocation
CMEs = Capital Market Expectations
UBL = Unconstrained Black Litterman
MCS = Monte Carlo Simulation

EF = Efficient Frontier
CPs = Corner Portfolios
CAL = Capital Allocation Line
BL = Black Litterman
HC = Human Capital

2. WHAT IS ASSET ALLOCATION

Major Types of Asset Allocation

Strategic Asset Allocation

Integrative element of the planning step in
portfolio management.
Investment objectives & constraints are
integrated with long-run CMEs to establish
exposures to IPS-permissible asset classes.
Portfolio constructed is called policy portfolio &
weights are called target weights.

Tactical Asset Allocation

Result of active management.
Deviation from SAA to take advantage of any
perceived short-term opportunities in the
market.

2.1 The Role of Strategic Asset Allocation in Relation to Systematic Risk

SAA specifies the investor’s desired exposure to systematic risk.
Each asset class has its own quantifiable systematic risk.
Groups of assets of the same type represent relatively similar
investments with similar risk factors.
SAA must review periodically or when investor’s needs or circumstances
∆ significantly.

2.3 The Empirical Debate on the Importance of Asset Allocation
Importance of Asset Allocation
Empirical studies conclude that asset allocation explains more than 90%
variations of return over time.
Research concluded that the sample pension funds & balanced funds are
not adding value through timing & security selection, after expense.

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2013, Study Session # 8, Reading # 21

3. ASSET ALLOCATION AND THE INVESTOR'S RISK AND RETURN OBJECTIVES

3.1 Asset-Only and Asset/Liability Management Approaches to Strategic Asset Allocation

ALM Approach to SAA

Explicitly model liabilities & adopt the optimal
asset allocation in relationship to funding
liabilities.
Quasi-liabilities ⇒ ALM approach adopted by
individuals by treating future needs as if they
were liabilities.

Risk Dimension

Risk Minimizing

CF Matching
Immunization

Asset-only Approach to SAA

Does not explicitly involve modeling liabilities.
Much less precision in controlling risk related to
the funding of liabilities.

Static V/S dynamic Dimension

Return Maximizing

Permit risk levels &
those specifying the
satisfaction of liabilities
as constraints.

Dynamic Approach

Asset allocations linked to the
optimal investment decisions
available at future time periods.

Static Approach

Ignores the link b/w optimal asset
allocations across different time
periods

3.2 Return Objectives and Strategic Asset Allocation

Qualitative Return Objectives

Describe the investor’s fundamental goals (e.g.
adequate retirement income).

Quantitative Return Objectives

Return & risk levels perceived to be appropriate for
achieving the qualitative objectives.
Multiplicative formulation & the effects of compounding
must be considered due to long-term nature of SAA.

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2013, Study Session # 8, Reading # 21

3.3 Risk Objectives and Strategic Asset Allocation

Qualitative

Quantitative

Below avg, avg & above avg

Measures the investor’s numerical risk aversion (risk
aversion scores).
ܷ௠ = ‫ܧ‬ሺܴ௠ ሻ − 0.005ܴ஺ ߪெଶ
Where
ܷ௠ = investor’s expected utility for asset mix m.
‫ܧ‬ሺܴ௠ ሻ = % expected return.
ܴ஺ = Risk aversion score
ߪெଶ = variance of return (%σ) 2
Other risk measures are SD & downside risk measures.
Downside risk measures:
Shortfall risk ⇒ risk that portfolio’s value will fall
below some minimum acceptable level.
Measured through Roy’s safety first criteria:
‫ܧ‬ሺܴ௉ ሻ − ܴ௅

ܵ‫ = ݋݅ݐܴܽܨ‬
ߪ௉
Semi variance.
Target semi variance.

3.4 Behavioral Influences on Asset Allocation

Loss Aversion

Mental Accounting

If client is loss averse, incorporate an
appropriate shortfall risk constraint.
ALM approach may be appropriate.

Place total wealth into separate
accounts & buckets.
Multi-strategy or goal-based asset
allocation.

Regret Avoidance

Psychological factor promoting lack
of diversification.
Leads to investing in comfortable
investment.

4. THE SELECTION OF ASSET CLASSES

Asset class is a group of assets with similar attributes

4.1 Criteria for Specifying Asset Classes

Criteria that helps in effectively specifying asset classes:
Relatively homogenous assets within an asset class.
Asset classes should not be highly correlated (provide desired
diversification).
Individual assets can’t be classified into more than one class.
Asset classes should cover the majority of all possible investable
assets.
Asset classes must contain sufficiently large % of liquid assets.

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2013, Study Session # 8, Reading # 21

4.2 The Inclusion of International Assets (Developed and Emerging Markets)

Adding a new asset (or asset class) to the portfolio is optimal if:
‫ݏ‬ℎܽ‫݋݅ݐܽݎ݁݌ݎ‬௡௘௪ > ‫ݏ‬ℎܽ‫݋݅ݐܽݎ݁݌ݎ‬௉ × ‫ݎݎ݋ܥ‬ሺܴ௡௘௪ , ܴ௉ ሻ
Add new asset if this relationship holds.
Provide no information about how much of the new asset to add.
When investing in international assets, consider the following special
issues:
Currency risk.
Emerging market concerns.
Correlation in times of stress.

4.3 Alternative Investments

Meaningful diversification benefits from exposure to alternative asset
classes.
Some concerns include:
Need to carefully select outperformers.
Information may be non-existent.
Sufficient resources required to research investment in these
groups.

5. THE STEPS IN ASSET ALLOCATION

IPS

CMEs

Mix of assets (portfolio)

Monitoring & Rebalancing

6. OPTIMIZATION

Procedure of converting the inputs to a specific
recommended SAA.

6.1 The Mean-Variance Approach

6.1.1 The Efficient Frontier

Investor chooses from among the efficient portfolios in determining SAA.
EF ⇒ upper portion of minimum variance frontier (MVF) containing

efficient portfolios.
Global minimum variance (GMV) portfolio ⇒ left most point of the MVF &
has the smallest variance of all MV portfolios.

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2013, Study Session # 8, Reading # 21

Minimum Variance Frontier

The Unconstrained MVF

The Sign-Constrained MVF

No constraints on asset class weights
except that the weights sum to 1.
Weights of two minimum variance
portfolios are required to know the
weights of any other MV portfolio.

Asset class weights to be non-negative & sum to 1.
This constraint creates adjacent corner portfolios.
The GMV portfolio is a corner portfolio irrespective of its asset
weights.
Knowing the composition of the two adjacent CPs allows the
computation of the weights of any portfolio on the MVF.

6.1.2 The Importance of the Quality of Inputs

Asset allocations are highly sensitive to small ∆ in inputs.
Most important input to MVO ⇒ E(R) ⇒ subject to estimation error.

6.1.3 Selecting an Efficient Portfolio

If more than one portfolio satisfies the risk & returns criteria, choose the portfolio
with highest Sharpe ratio.
If no efficient portfolio exists that is consistent with the investors stated return &
risk objectives, investor must reconsider his return & risk objective in light of his
circumstances.

Cash Equivalents and Capital Market Theory

If the investor can borrow or lend at RF, choose the asset allocation represented by
the tangency portfolio fall on CAL.
If required return > tangency portfolio return use margin to leverage the
position.
If margin is not allowed, choose a portfolio to the right of the tangency point
on the EF.
Investor should set aside an amount equal to PV of short-term liquidity needs &
determine appropriate allocation for the balance of wealth.

6.2 The Resampled Efficient Frontier

Traditional MVO is very sensitive to small changes in inputs.
Michaud approach to asset allocation ⇒ based on a simulation exercise using MVO
& a data set of historical return.
A sample of historical MV inputs is used in a simulation & generates simulated

returns.
Simulated returns are used in MVO to produce the portfolio weights of a
specified no. of MV efficient portfolios.
Benefits:
More diversified & more stable portfolios.
Most or all asset classes are typically represented in the resampled EF.
Drawbacks:
Lack of theoretical foundation.
Historical return frequency data may not be relevant to current asset market
values & equilibrium.

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2013, Study Session # 8, Reading # 21

6.3 The Black-Litterman Approach

Minimum Variance Frontier

UBL Model

BL Model

Weights from asset classes in a global
benchmark.

Weights are adjusted to reflect investor’s
views.
Direct method for selecting an asset
allocation.
Well diversified portfolios with small or
moderate deviation from the benchmark.

Reverse engineers the E(R) implicit in a
diversified market portfolio & combines
them with investor’s own views.
These E(R) forecasts are then use in a MVO
with a constraint against short sales.
Benefits:
Well diversified allocation.
Allocation incorporates the investor’s
views & strength of those views.

6.4 Monte Carlo Simulation

Computer based process that utilizes inputs specified by the manager.
Using different strategic asset allocations the program incorporates the effects of
various assumed capital market factors in the next as well as several future
periods.
Model overcomes the static nature of the typically MV analysis.
Value of wealth at the terminal point of an investor’s horizon is a criterion for
choosing among asset allocations.

6.5 Asset/Liability Management

Focuses on the surplus EF to incorporate the investor’s liabilities.

Surplus β decision ⇒ policy portfolio on surplus EF that satisfies investor’s risk
tolerance.
Estimation error problem (Resampled & the Black Litterman model to handle this
problem).

Asset/Liability Modeling with Simulation

Managers often use MCS together with surplus optimization & follow these steps:
Select a limited set of efficient portfolios from surplus efficient frontier.
Conduct a MCS.
Choose the most appropriate allocation.

6.6 Experience-Based Approaches

These techniques have come about through decades of
experience.
60/40 rule (60% equities & 40% bonds) is considered a neutral
approach as a starting point.
A rule of thumb for the % allocation to equities is 100-age of
the investor.
Time diversification ⇒ investors with longer time horizons
should their allocation to stocks.

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2013, Study Session # 8, Reading # 21

7. IMPLEMENTING THE STRATEGIC ASSET ALLOCATION

7.1 Implementation Choices

Passive Investing

Active Investing

Semi-Active Investing

Can be implemented through:
Tracking portfolio of cash market
securities.
Cash position plus long position in
swap on index.
Cash position plus long position in
index futures.

Can be implemented through:
Portfolio cash market securities.
Derivative based position plus a
market neutral long-short position.

Can be implemented through:
Tracking portfolio of cash market
securities.
Derivative position plus controlled
active risk in the cash position.

7.2 Currency Risk Management Decisions

In case of nondomestic asset class, the investor’s portfolio
will be exposed to currency risk.
Currency hedging can be managed passively or actively.
Asset allocation & currency hedging decisions can be
optimized jointly or independently by delegating the
currency management function to a currency overlay
manager.

7.3 Rebalancing to the Strategic Asset Allocation

Rebalancing may be done on a calendar basis or on a % of
portfolio basis.

8. STRATEGIC ASSET ALLOCATION FOR INDIVIDUAL INVESTORS

Asset allocation of individual investors must account for:
Current & future labor income.
Correlation b/w human capital & financial capital return.
Possibility of outliving one’s resources.

8.1 Human Capital

HC ⇒ the PV of expected future labor income.
Strategic asset allocation must consider human capital.
If HC is highly +vely correlated with stock markets ⇒ less exposure to
stocks.
An Investor allocates more to stocks as a young person than as an old
person.

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2013, Study Session # 8, Reading # 21

8.2 Other Considerations in Asset Allocation for Individual Investors

Mortality Risk

Longevity Risk

Risk of HC loss if an investor dies
prematurely.
Life insurance is used to hedge this risk.
Suggest the holding of liquidity reserve
fund.

Risk that the investor will outlive his/her
assets in retirement.
A life annuity is used to hedge longevity risk.
Longevity risk should be directly related to
asset allocation.

9. STRATEGIC ASSET ALLOCATION FOR INSTITUTIONAL INVESTORS

9.1 Defined-Benefit Plans

Strong focus on ALM techniques.
Subject to regulatory & liquidity constraints.
AO perspective ⇒ asset allocation with the lowest risk

that meets the return objective of the pension fund.

9.2 Foundations and Endowments

Need a high long-term rate of return (to meet spending
flow & inflation expectations).
Inflation rates relevant to endowment may be different
than economy growth.

9.3 Insurance Companies

Usually ALM approach is used to meet contractual
liabilities.
Segmented portfolio is a distinct feature of life insurer’s
investment activities.
Insurers now use a much wider array of investment
vehicles.
Life (casualty) insurer maintains limited (high) liquidity.

9.4 Banks

Subject to regulatory restrictions & risk based capital
rules.
Public policy usually views bank portfolio as “quasi public
trust funds”.

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2013, Study Session # 8, Reading # 21

10. TACTICAL ASSET ALLOCATION

Active management at asset-class level.
Can be conducted independently within-class investment decision by using
derivative securities.
Principles of TAA:
MP tells explicitly what returns are available.
Relative expected returns reflect relative risk perceptions.
Markets are rational & mean reverting.
Close attention should be given to risks & costs.

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