CFA 2018 r16 introduction to asset allocation

Structure Portfolio Strategic asset allocation Active risk budgets Manager selection Security selection Execution of portfolio Investment Governance... The Investment Governance Backgro

Contents and Introduction

1 Introduction

2 Asset Allocation: Importance in Investment Management

3 The Investment Governance Background to Asset Allocation

4 The Economic Balance Sheet and Asset Allocation

5 Approaches to Asset Allocation

6 Strategic Asset Allocation

7 Implementation Choices

8 Rebalancing: Strategic Considerations

2 Asset Allocation: Importance in Investment Management

Identify and articulate asset owner’s

objectives.

Document objectives and constraints

in the IPS

Identify changes in economic balance

sheet, objectives and constraints.

Develop capital market expectations for

the planning horizon.

Monitor prices and markets.

Evaluate progress towards achieving objectives and compliance with IPS.

Structure Portfolio

Strategic asset allocation Active risk budgets Manager selection Security selection Execution of portfolio

Investment Governance

3 The Investment Governance Background to Asset Allocation

• Investment governance is the structure which helps ensure that assets are invested to achieve the

asset owner’s investment objectives within the asset owner’s risk tolerance and constraints

▪ Includes organization of decision-making responsibilities and oversight activities

▪ Investment actions must comply with laws and regulations

• Good governance  good investment performance

This section covers:

1 Governance Structures

2 Articulating Investment Objectives

3 Allocation of Rights and Responsibilities

4 Investment Policy Statement

5 Asset Allocation and Rebalancing Policy

6 Reporting Framework

7 The Governance Audit

In this reading, governance structures are discussed in the context of defined pension benefit plans;

however, the lessons learned here also apply to other types of investors.

3.1 Governance Structures

• Governance and management are separate but related functions

▪ Governance: clarify the mission, create a plan, and review progress

▪ Management effort is focused on outcomes: execution of the plan to achieve agreed-on goals

• A common governance structure in an institutional investor context will have three levels

1) governing investment committee 2) investment staff and 3) third-party resources

Effective governance models perform the following tasks:

1 Articulate the long-term and short-term objectives of the investment program.

2 Allocate decision rights and responsibilities among the functional units in the governance hierarchy

effectively, taking account of their knowledge, capacity, time, and position in the governance hierarchy.

3 Specify processes for developing and approving the investment policy statement that will govern the

day-to-day operations of the investment program.

4 Specify processes for developing and approving the program’s strategic asset allocation.

5 Establish a reporting framework to monitor the program’s progress toward the agreed-on goals and

objectives.

6 Periodically undertake a governance audit.

3.2 Articulating Investment Objectives

Long-term and short-term objectives clarify what an investor is trying to achieve and give context to the return requirement

• Determine and communicate risk tolerance

• Consider cash inflows and outflows characteristics

• Consider liquidity needs

• Find the best risk-return trade-off, given constraints and risk tolerance

3.3 Allocation of Rights and Responsibilities

• Rights and responsibilities necessary to execute the investment program are generally determined

at the highest level of investment governance

• Resource availability  scope and complexity of investment program

• Individuals must have the necessary knowledge and expertise

• Next slide reproduces Exhibit 2: Allocation of Rights and Responsibilities

Investment Activity Investment Committee Investment Staff Third-Party Resource

Asset allocation policy Approve with input from staff and

Research, evaluation, and selection of investment managers and service providers

Consultants provide input

Monitoring asset prices

& portfolio rebalancing

Delegate to staff within confines of the investment policy statement

Assure that the sum of all sub-portfolios equals the desired overall portfolio positioning; approve and execute rebalancing

Consultants and custodian provide input

Risk management Approve principles and conduct

Oversight Evaluate manager’s continued suitability

for assigned role; analyze sources of portfolio return

Consultants and custodian provide input

Governance audit Commission and assess Responds and corrects Investment Committee contracts with an

independent third party for the audit

3.4 Investment Policy Statement

The investment policy statement (IPS) is the foundation of an effective investment program

• Frequency and nature of reporting

3.5 Asset Allocation and Rebalancing Policy

• IPS should contain ‘general orienting information relevant to rebalancing’

• IPS should specify who is responsible for defining the rebalancing policy

3.6 Reporting Framework

Reporting should allow overseers to evaluate progress of investment program; it should address :

• Where are we now?

• Where are we relative to the goals and objectives?

• What value has been added or subtracted by management decisions?

Reporting framework should address performance evaluation, compliance with investment

guidelines, and progress toward achieving the stated goals and objectives

Benchmarking, management reporting, governance reporting

3.7 The Governance Audit

• Ensures that the established policies, procedures, and governance structures are effective

• Should be performed by an independent third party

• Auditor examines fund’s governing documents, assesses the capacity to execute effectively, and

evaluates the existing portfolio for its “efficiency” given the governance constraints

• Good governance seeks to avoid decision-reversal risk

Example 1: Investment Governance, Case 1

In January 2016, the Cafastan Office Workers Union Pension (COWUP) made the following

announcement:

“COWUP will fully exit all hedge funds and funds of funds Assets currently amounting to 15% of its

investment program are involved Although hedge funds are a viable strategy for some, when judged against their complexity and cost, hedge fund investment is no longer warranted for COWUP.”

One week later, a financial news service reported the following:

“The COWUP decision on hedge funds was precipitated by an allegation of wrongdoing by a senior

executive with hedge fund selection responsibilities in COWUP’s alternative investments strategy

Example 1: Investment Governance, Case 2

The imaginary country of Cafastan has a sovereign wealth fund with assets of CAF$40 billion A

governance audit includes the following:

“The professional chief investment officer (CIO) reports to a nine-member appointed investment

committee board of directors headed by an executive director Investment staff members draft asset allocation policy in conjunction with consultants and make recommendation to the investment

committee; the investment committee reviews and approves policy and any changes in policy, including the strategic asset allocation The investment committee makes manager structure, conducts manager analysis, and makes manager selection decisions The CIO has built a staff organization, which includes heads for each major asset class In examining decisions over the last five years, we have noted several instances in which political or non-economic considerations appear to have influenced the investment program, including the selection of local private equity investments Generally, the board spends much

of its time debating individual manager strategies for inclusion in the portfolio and in evaluating

investment managers’ performance with comparatively little time devoted to asset allocation or risk management.”

Based on this information and that in Exhibit 2, identify sound and questionable governance practices

in the management of the Cafastan sovereign wealth fund

4 The Economic Balance Sheet and Asset Allocation

• An economic balance sheet includes:

▪ Conventional (financial) assets and liabilities

▪ Extended portfolio assets and liabilities

• For individual investors, extended portfolio assets/liabilities include:

▪ Assets: human capital, PV of pension income, PV of expected inheritances

▪ Liabilities: PV of future consumption

• For institutional investors, examples of extended portfolio assets/liabilities include:

▪ Assets: underground mineral resources, PV of future intellectual property royalties

▪ Liabilities: PV of prospective payouts for foundations

• Extended portfolio assets and liabilities should be considered in making asset

allocation decisions

Example 3: The Economic Balance Sheet of Auldberg University Endowment

Assets: Endowment assets include CAF$100 million in domestic equities, CAF$60 million in domestic government debt, and

CAF$40 million in Class B office real estate The present value of expected future contributions (from real estate and provincial

subsidies) is estimated to be CAF$400 million.

Liabilities: These include CAF$10 million in short-term borrowings and CAF$35 million in mortgage debt related to real estate

investments Although it has no specific legal requirement, AUE has a policy to distribute to the university 5% of 36-month

moving average net assets In effect, the endowment supports $10 million of Auldberg University’s annual operating budget The present value of expected future support is CAF$450 million.

PV of expected future contributions to AUE 400 PV of expected future support 450

5 Approaches to Asset Allocation

• Asset-only approach

▪ Focus is on the asset side; liabilities are not considered

▪ Example: Mean-variance optimization (MVO)

• Liability-relative approach

▪ Asset allocation is done with objective of funding liabilities (pay liabilities when they come due)

▪ Example: Surplus optimization

▪ Liability-driven investing (LDI)

• Goals-based approach

▪ Used primarily for individuals and families

▪ Sub-portfolios aligned with specific goals

▪ Specific asset allocation for each goal

▪ Goal-based investing (GBI)

Distinctions between liabilities for an institutional investor and goals for

an individual investor

Institutional Investor Liabilities

• Legal obligations or debts

• Institutional liabilities, such as life insurer

obligations or pension benefit obligations, are

uniform in nature

• Liabilities of institutional investors of a given

type (e.g., the pension benefits owed to

retirees) are often numerous and so, through

averaging, may often be forecast with

confidence

Individual Investor Goals

• Goals, such as meeting lifestyle or aspirational objectives, are not obligations

• An individual’s goals may be many and varied

• Individual goals are not subject to the law of large numbers and averaging

5.1 Relevant Objectives

Asset Allocation

Approach

Relation to Economic Balance Sheet Typical Objective Typical Uses and Asset Owner Types

Asset only Does not explicitly

model liabilities or goals

Maximize Sharpe ratio for acceptable level of volatility

Liabilities or goals not defined and/or simplicity is important

• Some foundations, endowments

• Sovereign wealth funds

5.2 Relevant Risk Concepts

Asset Allocation

Approach

Relation to Economic Balance Sheet Relevant Risk Concepts

Asset only Does not explicitly

model liabilities or goals

Primary risk measure is volatility of portfolio returns which depend

on asset class volatilities and correlation Risk relative to benchmark (tracking error) Downside risk

Monte Carlo simulations

Liability relative Models legal and

quasi-liabilities

Shortfall risk: risk of having insufficient assets to pay obligations when due

Goals based Models goals Risk of failing to achieve goals

Risk limits: maximum acceptable probability of not achieving goals Overall portfolio risk is the weighted sum of the risks associated with each goal

5.3 Modeling Asset Class Risk

Asset class: “a set of assets that bear some fundamental economic similarities to each other, and that have characteristics that make them distinct from other assets that are not part of that class.”

• Greer’s three super classes of assets

▪ Capital assets

▪ Consumable/transformable assets

▪ Store of value assets

Example 4: Classify the following investments based on Greer’s (1997) framework, or explain how they do not fit

Criteria for Asset Class Specification

The following five criteria help in effectively specifying asset classes for the purpose of asset allocation:

1 Assets within an asset class should be relatively homogeneous

2 Asset classes should be mutually exclusive

3 Asset classes should be diversifying

4 The asset classes as a group should make up a preponderance of world investable wealth

5 Asset classes selected for investment should have the capacity to absorb a meaningful proportion

of an investor’s portfolio

Asset Classes In Practice

• Global public equity: domestic and non-domestic; developed, emerging, and frontier markets; cap, mid-cap, and small-cap

large-• Global private equity: venture capital, growth capital, and leveraged buyouts

• Global fixed income: developed and emerging market debt; sovereign, investment-grade, and yield bonds; inflation-linked bonds; cash and short-duration securities

high-• Real assets: assets that provide sensitivity to inflation, such as private real estate equity, private

infrastructure, and commodities

Note: Sometimes, global inflation-linked bonds are included as a real asset rather than fixed income because of their sensitivity to inflation.

Exhibit 6: Examples of Asset Classes and Sub-Asset Classes

Sources of risk for broadly defined asset classes (equity versus debt) are better distinguished than sources

of risk for narrowly defined subgroups (large cap versus small cap equity).

Exhibit 7: Common Factor Exposures across Asset Classes

• Even broadly defined asset classes (US equity and US Corporate Bonds) have some common risk factor exposures  non-zero correlation between asset classes

• Risk factors are associated with non-diversifiable (systematic)  expected return premium

Factor Representation

Examples of how risk factor exposures can be achieved:

• Inflation Going long nominal Treasuries and short inflation-linked bonds isolates the inflation component.

• Real interest rates Inflation-linked bonds provide a proxy for real interest rates.

• US volatility VIX (Chicago Board Options Exchange Volatility Index) futures provide a proxy for implied volatility.

• Credit spread Going long high-quality credit and short Treasuries/government bonds isolates credit exposure.

• Duration Going long 10+ year Treasuries and short 1–3 year Treasuries isolates the duration exposure being targeted.

Factor Models in Asset Allocation

The interest in using factors for asset allocation stems from:

• The desire to shape the asset allocation based on goals and objectives that cannot be expressed by asset classes

• An intense focus on portfolio risk in all of its various dimensions, helped along by availability of commercial

factor-based risk measurement and management tools.

• The acknowledgment that many highly correlated so-called asset classes are better defined as parts of the same high-level asset class

• The realization that equity risk can be the dominant risk exposure even in a seemingly well-diversified portfolio.