CFA 2018 level 1 CFA 2018 level 1 CFA level 3 schweser practice ExamCFA level 3 quest bank CFA level 3 summary NotesCFA level 3 study NotéCFA level 3 r18 asset allocation with real world constraints

Level III
Asset Allocation with Real-World Constraints
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Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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Contents and Introduction
1. Introduction
2. Constraints in Asset Allocation
3. Asset Allocation for the Taxable Investor

4. Revising the Strategic Asset Allocation
5. Short-Term Shifts in Asset Allocation

6. Dealing with Behavioral Biases in Asset Allocation

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2 Constraints in Asset Allocation
1. Asset Size

2. Liquidity
3. Time Horizon
4. Regulatory and Other External Constraints

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2.1 Asset Size
Portfolio might be too small to efficiently capture
the returns of certain asset classes and strategies
such as hedge funds, private equity and real estate

Reasons:
Economies of scale not achieved
• No enough resources for sophisticated
governance
• High management fee relative to AUM
• Low negotiation leverage
Too small to effectively diversify across asset
classes
Minimum investment requirements

Portfolio might be too large to efficiently capture
the returns of:
• asset classes with low market capitalization
• certain active strategies
Reasons:
• Asset class not large enough
• Large trades  high price impact
• Liquidity issues
• Overexposure to some fund managers
• Fund managers might be forced to make
investments outside area of expertise

• Organizational hierarchies slow down decision
making

Workaround: comingled vehicles

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Exhibit 1 Asset Size and Investor Constraints
Asset Class
Cash and money market funds

Investor Constraints by Size
No size constraints.

Large-cap developed market equity
Small-cap developed market equity
Emerging market equity
Developed market sovereign bonds
Investment-grade bonds
Non-investment-grade bonds
Private real estate equity
Alternative Investments
Hedge funds
Private debt
Private equity
Infrastructure
Timberland and farmland

Generally accessible to large and small asset owners, although the very
large asset owner may be constrained in the amount of assets allocated
to certain active strategies and managers.
Generally accessible to large and small asset owners, although to achieve
prudent diversification, smaller asset owners may need to implement via
a commingled vehicle.

May be accessible to large and small asset owners, although if offered as
private investment vehicles, there may be legal minimum qualifications
that exclude smaller asset owners. The ability to successfully invest in
these asset classes may also be limited by the asset owner’s level of
investment understanding/expertise. Prudent diversification may require
that smaller asset owners implement via a commingled vehicle, such as a
fund of funds, or an ancillary access channel, such as a liquid alternatives
vehicle or an alternatives ETF. For very large funds, the allocation may be
constrained by the number of funds available.
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Embedded Examples
An asset owner with an investment portfolio of US$25 billion is seeking to make a 5% investment in global small-cap stocks:
• The median total market capitalization of the stocks in the S&P Global SmallCap is approximately US$555 million.
• Assume a small-cap manager operates a 50-stock portfolio and is willing to own 3% of the market cap of any one of its portfolio
companies. Their average position size would be US$17 million, and an effective level of assets under management (AUM) would
be on the order of US$850 million. Beyond that level, the manager may be forced to expand the portfolio beyond 50 stocks or to
hold position sizes greater than 3% of a company’s market cap, which could then create liquidity issues for the manager.
• Now, our US$25 billion fund is looking to allocate US$1.25 billion to small-cap stocks (US$25 billion × 5%). They want to diversify

this allocation across three or four active managers—a reasonable allocation of governance resources in the context of all of the
fund’s investment activities. The average allocation per manager is approximately US$300 to US$400 million, which would
constitute between 35% and 50% of each manager’s AUM. This exposes both the asset owner and the investment manager to an
undesirable level of operational risk.
Where Asset Size Constrains Investment Opportunity
As of early 2016, the 10 largest sovereign wealth funds globally each exceed US$400 billion in assets. For a fund of this size, a 5%
allocation to hedge funds (the average sovereign wealth fund allocation) would imply US$20 billion to be deployed. The global hedge
fund industry manages approximately US$2.8 trillion in total; 73% of the funds manage less than US$100 million. The remaining 27%
of the funds (roughly 3,000) manage 72% of the industry’s AUM; their implied average AUM is therefore US$670 million. If we assume
that the asset owner would want to be no more than 20% of a firm’s AUM, we can infer that the average investment might be
approximately US$130 million. With US$20 billion to deploy, the fund would need to invest with nearly 150 funds to achieve a 5%
allocation to hedge funds.
Sources: Sovereign Wealth Fund Institute, BarclayHedge, Eurekahedge (2016).
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Example 1: Asset Size Constraints in Asset Allocation (1/3)
Akkarat Aromdee is the recently retired President of Alpha Beverage, a producer and distributor of energy drinks
throughout Southeast Asia. Upon retiring, the company provided a lump sum retirement payment of
THB880,000,000 (equivalent to €20 million), which was rolled over to a tax-deferred individual retirement savings
plan. Aside from these assets, Aromdee owns company stock worth about THB70,000,000. The stock is
infrequently traded. He has consulted with an investment adviser, and they are reviewing the following asset
allocation proposal:
Global equities
Global high-yield bonds
Domestic intermediate bonds
Hedge funds
Private equity

40%
15%
30%
10%
5%

Describe asset size constraints that Aromdee
might encounter in implementing this asset
allocation. Discuss possible means to address
them.

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Example 1: Asset Size Constraints in Asset Allocation (2/3)
The CAF$40 billion Government Petroleum Fund of Cafastan is overseen by a nine-member Investment
Committee. The chief investment officer has a staff with sector heads in global equities, global bonds, real estate,
hedge funds, and derivatives. The majority of assets are managed by outside investment managers. The
Investment Committee, of which you are a member, approves the asset allocation policy and makes manager
selection decisions. Staff has recommended an increase in the private equity allocation from its current 0% to 15%,
to be implemented over the next 12 to 36 months. The head of global equities will oversee the implementation of
the private equity allocation.
Given the asset size of the fund, formulate a set of questions regarding the feasibility of this recommendation that
you would like staff to address at the next Investment Committee meeting.

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Example 1: Asset Size Constraints in Asset Allocation (3/3)
The Courneuve University Endowment has US$250 million in assets. The current allocation is 65% global largecapitalization stocks and 35% high-quality bonds, with a duration target of 5.0 years. The University has adopted a
5% spending policy. University enrollment is stable and expected to remain so. A capital spending initiative of
US$100 million for new science buildings in the next three to seven years is being discussed, but it has not yet
been approved. The University has no dedicated investment staff and makes limited use of external resources.
Investment recommendations are formulated by the University’s treasurer and approved by the Investment
Committee, composed entirely of external board members.
The new president of the University has stated that he feels the current policy is overly restrictive, and he would
like to see a more diversified program that takes advantage of the types of investment strategies used by large
endowment programs. Choosing from among the following asset classes, propose a set of asset classes to be
considered in the revised asset allocation. Justify your response.
• Cash equivalents and money market funds

• Non-investment-grade bonds

• Large-cap developed market equity

• Private real estate equity

• Small-cap developed market equity

• Hedge funds

• Emerging market equity

• Private debt

• Developed market sovereign bonds

• Private equity

• Investment-grade bonds
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2.2 Liquidity
Liquidity
Needs of
Asset Owner

Liquidity
Characteristics of
Asset Classes

Investment
Opportunity Set

Time horizon
Liquidity needs under high market stress
Governance capacity
Consider particular circumstances, financial strength and resources beyond investment portfolio:
• A foundation whose mission supports medical research in a field in which a break-through appears
imminent may desire a higher level of liquidity to fund critical projects than would a foundation that
supports ongoing community efforts.
• An insurance company whose business is predominantly life or auto insurance, where losses are

actuarially predictable, can absorb more liquidity risk than a property/casualty reinsurer whose losses
are subject to unpredictable events, such as natural disasters.
• A family with several children nearing college-age will have higher liquidity needs than a couple of the
same age and circumstances with no children.
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Example 2: Liquidity Constraints in Asset Allocation
The Frentel Furniture Pension Fund has £200 million frozen in a defined benefit pension plan that is 85% funded.
The plan has a provision that allows employees to elect a lump sum distribution of their pension benefit at
retirement. The company is strong financially and is committed to fully funding the pension obligations over time.
However, they also want to minimize cash contributions to the plan. Few governance resources are allocated to the
pension fund, and there is no dedicated staff for pension investment activities. The current asset allocation is as
shown:
Global equities
20%
Private equity
10%
Real estate
10%
Infrastructure
5%
Hedge funds
15%
Bonds
40%
The company expects to reduce their employee headcount sometime in the next three to five years, and they are
tentatively planning incentives to encourage employees to retire early.

Discuss the appropriateness of the current asset allocation strategy for the pension fund, including benefits and
concerns.

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2.3 Time Horizon
In defining asset allocation time horizon must be considered; two major time-related constraints are:
• Changes in human capital
• Changing character of liabilities
Time horizon impacts how goals and liabilities are prioritized
Time diversification: belief that longer-horizon goals can tolerate higher volatility
“Although one-year returns are largely independent, there is some evidence that risky asset returns
can display mean-reverting tendencies over intermediate to longer time horizons. An assumption of
mean-reverting risky asset returns would support the conventional arguments for funding long-term
goals and liabilities with higher risk/higher return assets, and it would also support a reduction in
the allocation to these riskier assets as the time horizon shortens.”

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Example 3: Time Horizon Constraints in Asset Allocation
Akkarat Aromdee, the recently retired President of Alpha Beverage, is 67 years old with a remaining life expectancy
of 15 years. Upon his retirement two years ago, he established a charitable foundation and funded it with THB600
million (US$17.3 million). The remaining financial assets, THB350 million (US$10 million), were transferred to a
trust that will allow him to draw a lifetime income. The assets are invested 100% in fixed-income securities,

consistent with Aromdee’s desire for a high level of certainty in meeting his goals. He is a widower with no
children. His consumption needs are estimated at THB20 million annually. Assets remaining in the trust at his
death will pass to the charities named in the trust.
While vacationing in Ko Samui, Aromdee met and later married a 45-year-old woman with two teenage children.
She has limited financial assets of her own. Upon returning from his honeymoon, Aromdee meets with his
investment adviser. He intends to pay the college expenses of his new stepchildren—THB2 million annually for
eight years, beginning five years from now. He would also like to ensure that his portfolio can provide a modest
lifetime income for his wife after his death.
Discuss how these changed circumstances are likely to influence Aromdee’s asset allocation.

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2.4 Regulatory and Other External Constraints
External considerations impact asset allocation
Insurance Companies
• Allocations to certain asset classes might be constrained by regulator
• Need for capital to pay policy holder benefits
• Need to maintain financial strength ratings
Pension Funds
• Allocations to certain asset classes might be constrained by regulator
• Funding, accounting and tax constraints influence asset allocation
Endowments and Foundations
• Tax incentives
• Credit considerations
Sovereign Wealth Funds
• Regulations
• Cultural and religions factors

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Example 4: External Constraints and Asset Allocation (1/2)
An insurance company has traditionally invested its pension plan using the asset allocation strategy adopted for its
insurance assets: The pension assets are 95% invested in high-quality intermediate duration bonds and 5% in
global equities. The duration of pension liabilities is approximately 25 years. Until now, the company has always
made contributions sufficient to maintain a fully funded status. Although the company has a strong capability to
fund the plan adequately and a relatively high tolerance for variability in asset returns, as part of a refinement in
corporate strategy, management is now seeking to reduce long-term expected future cash contributions.
Management is willing to accept more risk in the asset return, but they would like to limit contribution risk and the
risk to the plan’s funded status. The Investment Committee is considering three asset allocation proposals for the
pension plan:
A. Maintain the current asset allocation with the same bond portfolio duration.
B. Increase the equity allocation and lengthen the bond portfolio duration to increase the hedge of the duration
risk in the liabilities.
C. Maintain the current asset allocation of 95% bonds and 5% global equities, but increase the duration of bond
investments.
Discuss the merits of each proposal.

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Example 4: External Constraints and Asset Allocation (2/2)
A multinational corporation headquartered in Mexico has acquired a former competitor in the United States. It will
maintain both the US pension plan with US$250 million in assets and the Mexican pension plan with MXN$18,600

million in assets (US$1 billion). Both plans are 95% funded and have similar liability profiles. The Mexican pension
trust has an asset allocation policy of 30% equities (10% invested in the Mexican equity market and 20% in equity
markets outside Mexico), 10% hedge funds, 10% private equity, and 50% bonds. The treasurer has proposed that
the company adopt a consistent asset allocation policy across all of the company’s pension plans worldwide.
Critique the treasurer’s proposal.

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3 Asset Allocation for the Taxable Investor

1. After-Tax Portfolio Optimization
2. Taxes and Portfolio Rebalancing
3. Strategies to Reduce Tax Impact

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3.1 After-Tax Portfolio Optimization
Portfolio optimization should be based on after-tax return and risk
• rat = rpt(1 – t) or rat = pdrpt(1 – td) + parpt(1 – tcg)
• σat = σpt(1 – t)
• Correlations are not impacted by taxes
Exhibit 7 Pre-Tax and After-Tax Asset Allocation Comparisons

Ultimate purpose of an asset

can be considered when
modeling tax adjustments.

Impact of taxes on asset allocation
depends on the riskiness of the portfolio.
Tax inefficient asset class are still
important in an after-tax context when
correlation with other asset classes is low.

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3.2 Taxes and Portfolio Rebalancing
• Rebalancing  realized capital gains  taxes
• Trade-off between benefits of tax minimization (which calls for less rebalancing) merits of
maintaining target asset allocation (frequent rebalancing)
• After-tax volatility < before-tax volatility  larger asset class movements to materially alter risk
profile of taxable portfolio  wider rebalancing ranges for taxable portfolios relative to tax exempt
portfolios

3.3 Strategies to Reduce Tax Impact
• Lower taxes through: tax loss harvesting (discussed in other readings) and strategic asset location
• Strategic asset location: place less tax efficient assets in tax-exempt or tax-deferred accounts; place
tax efficient assets (low tax rates and/or deferred capital gains) in taxable accounts
▪ For tax-deferred accounts: vat = vpt(1 – ti)
▪ Assuming three asset classes and two account types, optimization program uses six after-tax
asset classes

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Example 5: Asset Allocation and the Taxable Investor (1/2)
Sarah Moreau, 45 years old, is a mid-level manager at a consumer
products company. Her investment portfolio consists entirely of taxdeferred retirement savings accounts. Through careful savings and
investments, she is on track to accumulate sufficient assets to retire at
age 60. Her portfolio is currently allocated as indicated below:

Investment-grade bonds
High-yield bonds
Common stock–dividend income strategy
Common stock–total return strategy
Total portfolio

20%
20%
30%
30%
100%

The common stock–dividend income strategy focuses on income-oriented, high-dividend-paying stocks; the common stock–total
return strategy focuses on stocks that represent good, long-term opportunities but pay little to no dividend. For the purposes of
this example, we will assume that the expected long-term return is equivalent between the two strategies. Moreau has a high
comfort level with this portfolio and the overall level of risk it entails.
Moreau has recently inherited additional monies, doubling her investable assets. She intends to use this new, taxable portfolio to
support causes important to her personally over her lifetime. There is no change in her risk tolerance. She is interviewing
prospective investment managers and has asked each to recommend an asset allocation strategy for the new portfolio using the

same set of asset classes. She has received the following recommendations:
Investment-grade bonds
High-yield bonds
Common stock–dividend
income strategy
Common stock–total return
strategy
Total portfolio

A
20%
20%
30%

B
40%
0%
30%

C
30%
0%
0%

1. Which asset allocation is most appropriate for the
new portfolio? Justify your response.
2. How should Moreau distribute these investments
among her taxable and tax-exempt accounts?

30%

30%

70%

100%

100%

100%
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Example 5: Asset Allocation and the Taxable Investor (2/2)
You are a member of the Investment Committee for a multinational corporation, responsible for the supervision of two
portfolios. Both portfolios were established to fund retirement benefits: One is a tax-exempt defined benefit pension fund,
and the other is taxable, holding assets intended to fund non-exempt retirement benefits. The pension fund has a target
allocation of 70% equities and 30% fixed income, with a +/– 5% rebalancing range. There is no formal asset allocation policy
for the taxable portfolio; it has simply followed the same allocation adopted by the pension portfolio. Because of recent
strong equity market returns, both portfolios are now allocated 77% to equities and 23% to bonds. Management expects that
the equity markets will continue to produce strong returns in the near term. Staff has offered the following options for
rebalancing the portfolios:
A. Do not rebalance.
B. Rebalance both portfolios to the 70% equity/30% fixed-income target allocation.
C. Rebalance the tax-exempt portfolio to the 70% equity/30% fixed-income target allocation, but expand the rebalancing
range for the taxable portfolio.
Which recommendation is most appropriate? Justify your response.

larger asset class movements to materially alter risk profile of
taxable portfolio  wider rebalancing ranges for taxable
portfolios relative to tax exempt portfolios

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4 Revising the Strategic Asset Allocation
SAA should be reviewed periodically even if there is no change in investor circumstances.
Circumstances that might trigger a special review of the asset allocation policy include:

• Change in goals
Glide path: anticipate changes in risk
▪ Business conditions
appetite and implement pre-established
▪ Investor’s circumstances
changes to asset allocation in response.
• Change in constraints
▪ Size
▪ Liquidity needs
▪ Time horizon
▪ Regulatory or other external constraints
• Change in beliefs
▪ Change in economic environment  change in capital market expectations
▪ Change in trustees or committee members
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Example 6: Revising the Strategic Asset Allocation (1/3)
Auldberg University Endowment Fund (AUE) has assets totaling CAF$200 million. The current asset allocation is as follows:
• CAF$100 million in domestic equities
• CAF$60 million in domestic government debt
• CAF$40 million in Class B office real estate
AUE has historically distributed to the University 5% of the 36-month moving average of net assets, contributing approximately
CAF$10 million of Auldberg University’s CAF$60 million annual operating budget. Real estate income (from the University’s
CAF$350 million direct investment in domestic commercial real estate assets, including office buildings and industrial parks, much
of it near the campus) and provincial subsidies have been the main source of income to the University. Admission is free to all
citizens who qualify academically.
Growth in the Cafastan economy has been fueled by low interest rates, encouraging excess real estate development. There is a
strong probability that the economy will soon go into recession, negatively impacting both the property values and the income
potential of the University’s real estate holdings.
Gizi Horvath, a University alumnus, has recently announced an irrevocable CAF$200 million gift to AUE, to be paid in equal
installments over the next five years. AUE employs a well-qualified staff with substantial diverse experience in equities, fixed
income, and real estate. Staff has recommended that the gift from Ms. Horvath be invested using the same asset allocation policy
that the endowment has been following successfully for the past five years. They suggest that the asset allocation policy should
be revisited once the final installment has been received.
Critique staff’s recommendation, and identify the case facts that support your critique.

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Example 6: Revising the Strategic Asset Allocation (2/3)
The Government Petroleum Fund of Cafastan (GPFC) is operating under the following asset allocation policy, which was
developed with a 20-year planning horizon. Target weights and actual weights are given:

Global equities
Global high-yield bonds
Domestic intermediate bonds
Hedge funds
Private equity

Target Asset Allocation
30%
10%
30%
15%
15%

Current Asset Allocation
38%
15%
25%
15%
7%

When this asset allocation policy was adopted 5 years ago, the petroleum revenues that support the sovereign wealth fund were
projected to continue to grow for at least the next 25 years and intergenerational distributions were expected to begin in 20
years. However, since the adoption of this policy, alternate fuel sources have eroded both the price and quantity of oil exports,
the economy is undergoing significant restructuring, inflows to the fund have been suspended, and distributions are expected to
begin within 5 years.
What are the implications of this change in the liquidity constraints for the current asset allocation policy?

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Example 6: Revising the Strategic Asset Allocation (3/3)
O-Chem Corp has a defined benefit pension plan with US$1.0 billion in assets. The plan is closed, the liabilities are frozen, and the
plan is currently 65% funded. The company intends to increase cash contributions to improve the funded status of the plan and
then purchase annuities to fully address all of the plan’s pension obligations. As part of an asset allocation analysis conducted
every five years, the company has recently decided to allocate 80% of assets to liability-matching bonds and the remaining 20%
to a mix of global equities and real estate. An existing private equity portfolio is in the midst of being liquidated. This allocation
reflects a desired reduction in the level of investment risk.
O-Chem has just announced an ambitious US$15 billion capital investment program to build new plants for refining and
production. The CFO informed the Pension Committee that the company will be contributing to the plan only the minimum
funding required by regulations for the foreseeable future. It is estimated that achieving fully funded status for the pension plan
under minimum funding requirements and using the current asset allocation approach will take at least 10 years.

What are the implications of this change in funding policy for the pension plan’s asset allocation strategy?

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