SAA = Strategic Asset Allocation TAA = Tactical Asset Allocation CMEs = Capital Market Expectations UBL = Unconstrained Black Litterman MCS = Monte Carlo Simulation EF = Efficient Fronti
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2 WHAT IS 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
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
Major Types of Asset Allocation
Result of active management
Deviation from SAA to take advantage of any perceived short-term opportunities in the market
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
2.1 The Role of Strategic Asset Allocation in Relation to Systematic Risk
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
2.3 The Empirical Debate on the Importance of Asset Allocation
Importance of Asset Allocation
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Explicitly model liabilities & adopt the optimal asset allocation in relationship to funding liabilities
individuals by treating future needs as if they were liabilities
3.1 Asset-Only and Asset/Liability Management Approaches to Strategic Asset Allocation
Does not explicitly involve modeling liabilities
Much less precision in controlling risk related to the funding of liabilities
CF Matching
Immunization
Permit risk levels &
those specifying the satisfaction of liabilities
as constraints
Asset allocations linked to the optimal investment decisions available at future time periods
Ignores the link b/w optimal asset allocations across different time periods
Describe the investor’s fundamental goals (e.g
adequate retirement income)
3.2 Return Objectives and Strategic Asset Allocation
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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Below avg, avg & above avg
3.3 Risk Objectives and Strategic Asset Allocation
= −
Measures the investor’s numerical risk aversion (risk aversion scores)
= − 0.005 ெ ଶ
Where
= investor’s expected utility for asset mix m
= % expected return
= Risk aversion score ெଶ = 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:
Semi variance
Target semi variance
3.4 Behavioral Influences on Asset Allocation
Place total wealth into separate accounts & buckets
Multi-strategy or goal-based asset allocation
Loss Aversion
If client is loss averse, incorporate an appropriate shortfall risk constraint
ALM approach may be appropriate
Regret Avoidance
Psychological factor promoting lack
of diversification
Leads to investing in comfortable investment
Mental Accounting
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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ℎ ௪>ℎ × ௪,
Adding a new asset (or asset class) to the portfolio is optimal if:
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
Mix of assets (portfolio)
Monitoring & Rebalancing
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
efficient portfolios
Global minimum variance (GMV) portfolio ⇒ left most point of the MVF &
has the smallest variance of all MV portfolios
6 OPTIMIZATION
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Minimum Variance Frontier
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
More diversified & more stable portfolios
Most or all asset classes are typically represented in the resampled EF
Lack of theoretical foundation
Historical return frequency data may not be relevant to current asset market values & equilibrium
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Minimum Variance Frontier
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
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
approach as a starting point
A rule of thumb for the % allocation to equities is 100-age of the investor
should their allocation to stocks
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7 IMPLEMENTING THE STRATEGIC ASSET ALLOCATION
7.1 Implementation Choices
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
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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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
Strong focus on ALM techniques
Subject to regulatory & liquidity constraints
that meets the return objective of the pension fund
9.1 Defined-Benefit Plans
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
9.2 Foundations and Endowments
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
9.3 Insurance Companies
Subject to regulatory restrictions & risk based capital rules
Public policy usually views bank portfolio as “quasi public trust funds”
9.4 Banks
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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
... Strategic Asset AllocationRebalancing may be done on a calendar basis or on a % of portfolio basis
8 STRATEGIC ASSET ALLOCATION FOR INDIVIDUAL INVESTORS
Asset allocation. .. 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. .. 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