CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r16 introduction to asset allocation IFT notes

Asset Allocation: Importance in Investment Management Asset allocation is generally defined as the allocation of an investor’s portfolio across a number of asset classes.. 3 THE INVESTM

Introduction to Asset Allocation

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1 Introduction 3

2 Asset Allocation: Importance in Investment Management 3

3 The Investment Governance Background to Asset Allocation Error! Bookmark not defined 3.1 Governance Structures Error! Bookmark not defined 3.2 Articulating Investment Objectives 4

3.3 Allocation of Rights and Responsibilities Error! Bookmark not defined 3.4 Investment Policy Statement Error! Bookmark not defined 3.5 Asset Allocation and Rebalancing Policy Error! Bookmark not defined 3.6 Reporting Framework Error! Bookmark not defined 3.7 The Governance Audit 7

4 The Economic Balance sheet and Asset Allocation 8

5 Approaches to Asset Allocation 9

5.1 Relevant Objectives 10

5.2 Relevant Risk Concepts 11

5.3 Modeling Asset Class Risk 12

6 Strategic Asset Allocation 15

6.1 Asset Only Error! Bookmark not defined 6.2 Liability Relative Error! Bookmark not defined 6.3 Goals Based 20

7 Implemention Choices Error! Bookmark not defined 7.1 Passive/Active Management of Asset Class Weights Error! Bookmark not defined 7.2 Passive/Active Management of Allocations to Asset Classes Error! Bookmark not defined 7.3 Risk Budgeting Perspectives in Asset Allocation and Implementation Error! Bookmark not defined 8 Rebalancing: Strategic Considerations Error! Bookmark not defined 8.1 A Framework for Rebalancing Error! Bookmark not defined 8.2 Strategic Considerations in Rebalancing Error! Bookmark not defined Summary from the Curriculum 8

Examples from the Curriculum 31

Example 1 Investment Governance: Hypothetical Case (1) 31

Example 2 Investment Governance: Hypothetical Case (2) Error! Bookmark not defined Example 3 The Economic Balance Sheet of Auldberg University Endowment 30

Example 4 Asset Classes (1) 31

Example 5 Assset Classes (2) Error! Bookmark not defined Example 6 Asset-Only Asset Allocation Error! Bookmark not defined Example 7 Goals-Based Asset Allocation Error! Bookmark not defined Example 8 Implementation Choices (1) Error! Bookmark not defined Example 9 Implementation Choices (2) Error! Bookmark not defined Example 10 Different Rebalancing Ranges Error! Bookmark not defined

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

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1 Introduction

This reading is a part of a sequence of three readings that will cover asset allocation The role of this introductory reading is to provide us a ‘big picture’ of asset allocation In the next reading ‘Principles of Asset Allocation’ we will learn ‘how’ to develop an asset allocation and in the third reading ‘Asset Allocation with Real-World Constraints’ we will learn about the real-world challenges in developing an asset allocation

2 Asset Allocation: Importance in Investment Management

Asset allocation is generally defined as the allocation of an investor’s portfolio across a number of asset classes Investment performance depends on asset allocation and its implementation, which implies that the asset allocation is one of the most important decisions in the investment process Exhibit 1 below shows that in portfolio management process, the investment opportunity set (on the right) should match the investor’s objectives (on the left)

As reflected on the left hand-side of the Exhibit 1, we first need to identify and articulate the asset owner’s objectives by understanding his economic balance sheet, investment constraints, and preferences Once the objectives are identified, these need to be properly documented in the IPS Besides investment objectives and constraints, IPS should identify rules and responsibilities, pre-defined review process and rebalancing strategies, and other principles related to investment management process Simultaneously, as shown on the right hand side, we also need to develop capital market expectations for the appropriate planning horizon of asset owner Both of these activities help us in creating a structure of a portfolio, which includes the following:

1) Strategic asset allocation (e.g 60% allocation to equities, 30% allocation to bonds, and 10% to commodities)

2) Active risk budgets, based on risk tolerance of an asset owner

3) Manager selection

4) Security selection

5) Execution of portfolio, which involves the actual creation of the portfolio

The lower section of left hand-side of Exhibit 1 reflects that with passage of time, we need to identify changes in the economic balance sheet, objectives and constraints of asset because any changes in the asset owner objectives and constraints would impact the IPS and which would subsequently affect the portfolio structure At the same time, we also need to monitor changes in asset prices and markets (if any) because any changes in prices or market conditions would have an impact on market expectations which would subsequently affect the asset allocation

The lower part of Exhibit 1 shows that we need to evaluate progress towards achieving objectives and compliance with IPS on a regular basis to ensure that the portfolio structure is align with the asset owner objectives through time

The entire asset allocation process rests on the foundation of strong investment governance, which includes the assignment of investment decision making authority to qualified individuals as well as the oversight of this entire process

Source: CFA Curriculum

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 Investment governance focuses on the organization of decision-making responsibilities and oversight activities and compliance of investment actions with laws and regulations Good investment governance practices (such as clear articulation of roles and responsibilities) allow investment managers to better achieve the asset owner’s stated goals by aligning his asset allocation and implementation processes

3.1 Governance Structures

Governance and management are separate but related functions Governance involves specifying the mission, creating a plan, and reviewing progress; whereas, management focuses on execution of the plan to achieve agreed-on goals

A common governance structure in an institutional investor context has the following three levels within the governance hierarchy:

1 governing investment committee

2 investment staff

3 third-party resources

This section addresses LO.a:

LO.a: Describe elements of effective investment governance and investment governance considerations in asset allocation;

Elements of effective investment governance: The effective investment governance models perform

the following tasks:

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

2) Allocate decision rights and responsibilities among the functional units in the governance hierarchy effectively depending on 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) Undertake a governance audit on periodic basis

Over the next few sections we will discuss each of these elements in detail

Instructor’s tip: You can use the acronym ‘ODISRA’ to remember these steps

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 In coming up with these investment objectives we need to:

 Determine and communicate risk tolerance

 Consider cash inflows and outflow characteristics

 Consider liquidity needs

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

Examples of investment objectives linked with purposes/goals:

1 Defined benefit pension fund The investment objective of the fund is to ensure that sufficient plan

2 Endowment fund The investment objective of the endowment is to earn a rate of return that

exceeds the spending rate plus the costs of managing the investment fund, expressed in real (or

inflation adjusted) terms

3 Individual investor The investment objective of an individual investor is to earn a rate of return that

will fund his retirement needs, family needs, bequests etc, taking into account his risk tolerance and

investment constraints

3.3 Allocation of Rights and Responsibilities

Effective investment governance rests on the proper allocation of rights and responsibilities across the

governance hierarchy The decision of allocation of these rights and responsibilities is generally

determined at the highest level of investment governance, depending on the available knowledge and

expertise at each level of the hierarchy, the resource capacity of the decision makers, and the ability to

act on a timely basis The resource availability has an impact on the scope and complexity of the

investment program

The table below summarizes the allocation of duties and responsibilities from mission development to

investment governance audit

Exhibit 2: Allocation of Rights and Responsibilities (reproduced from CFA Curriculum)

Investment Activity Investment Committee Investment Staff Third-party Resource

Asset allocation Policy Approve with input from

staff and consultant

Draft with input from consultants Consultants provide input Investment manager and

other service provider

selection

Delegate to investment staff;

approval authority retained for certain service providers

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

Consultants provide input

Portfolio construction

(individual asset selection)

Delegate to outside managers, or to staff if sufficient internal resources

Execution if assets are managed in-house

Execution by independent investment manager 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

Investment manager manages portfolio within established risk guidelines; consultants may provide input and support Investment manager

monitoring Oversight Ongoing assessment of managers Consultants and custodian provide input Performance evaluation and

reporting

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 Typical

features of an IPS include the following:

1) Introduction –Describes the purpose and scope of the document itself and the asset owner It may

also provide information about the following:

 business environment in which the asset owner operates and the sources and uses of

program assets;

 laws and regulations that govern the investment program;

2) Investment objective statement- Specifies an asset owner’s philosophy with respect to pursuing

investment returns subject to his investment constraints

3) Investment constraints – Specifies the constraints that directly affect the asset allocation decision of

the asset owner, i.e liquidity requirements, time horizon, tax concerns, legal and regulatory factors,

and unique circumstances (LLTTU)

4) Allocation of decision rights and responsibilities among the investment committee, investment staff,

and any third-party service providers

5) Investment guidelines that are needed to be followed in implementation (e.g., permissible use of

leverage and derivatives, exclusion of specific types of assets etc)

6) Frequency and nature of reporting to the investment committee and to the board of directors

7) Risk management framework – specifying the overall level of risk that is acceptable and providing

guidance in the allocation of that risk budget among asset classes

3.5 Asset Allocation and Rebalancing Policy

The IPS should contain the information relevant to rebalancing (i.e rebalancing policy) as the

specification of rebalancing responsibilities reflects good governance For example, in case of

institutional investors, the rebalancing policy may be the responsibility of the investment committee,

organizational staff, or the external consultant Likewise, for individual investors, the rebalancing policy

may be delegated to an investment adviser

3.6 Reporting Framework

A reporting framework is necessary to evaluate how well the investment program is progressing toward

the agreed-on goals and objectives It should address performance evaluation, compliance with

investment guidelines, and progress toward achieving the stated goals and objectives

Key elements of a reporting framework:

a) Benchmarking: Effective benchmarking facilitates the investment committee in performance

measurement, attribution, and evaluation of staff as well as external managers There can be two

separate levels of benchmarks

purpose for which they were hired;

ii Benchmark that measures the gap between the policy portfolio and the portfolio as actually implemented

b) Management reporting: It provides information about performance of different segments of the portfolio and adherence to investment guidelines This reporting is generally prepared by the staff with inputs from consultants and custodians

c) Governance reporting: Governance reporting helps identifying the strengths and weaknesses of the program execution It should be structured in a simpler manner so that any weaknesses that are identified can be addressed relatively easily

3.7 The Governance Audit

The governance audit is performed by an independent third party (called the governance auditor) to examine the fund’s governing documents, assess the capacity of the organization to execute effectively within the confines of those governing documents, and evaluate the efficiency of existing portfolio given the governance constraints

Besides ensuring accountability in investment management process, the good investment governance provides the following benefits:

 Good investment governance helps the investment committee to avoid “decision-reversal risk”, which is the risk of reversing a selected course of action at the wrong time (or at the point of

maximum loss) This is done by providing new committee members with proper orientation sessions

so that they are able to easily perceive the design and intent of the investment program and

continue to execute it

 Good investment governance helps avoid the “key person risk”, which is the risk of overreliance on any one staff member or long-term, illiquid investments dependent on a staff member

See Example 1, which helps in identifying facts, consistent with effective investment governance, needed in making investment decisions as well as the possible deficiencies in investment governance Refer to Example 1 from the curriculum

Refer to Example 2 from the curriculum which discusses about governance practices in investment management

4 THE ECONOMIC BALANCE SHEET AND ASSET ALLOCATION

This section addresses LO.b:

LO.b: prepare an economic balance sheet for a client and interpret its implications for asset allocation;

In order to develop an appropriate asset allocation, it is necessary to consider both the financial

portfolio and extended portfolio asset and liabilities of asset owners

Unlike conventional balance sheet which comprises financial asset and liabilities, an economic balance sheet includes both the financial assets / liabilities and extended portfolio assets and liabilities that are

relevant in making asset allocation decisions

Components of economic balance sheet of individual investors:

 Extended portfolio assets include human capital (the present value of future earnings), the present value of pension income, and the present value of expected inheritances

 Extended portfolio liability includes present value of future consumption

Components of economic balance sheet of institutional investors:

 Extended portfolio assets would include items like underground mineral resources or the

present value of future intellectual property royalties

 Extended portfolio liabilities would include items like the present value of prospective payouts for foundations

Refer to Example 3 from the curriculum

5 APPROACHES TO ASSET ALLOCATION

There are three broad approaches to asset allocation:

1 Asset-only (AO) approaches: AO approaches only focus on the asset side of the investor’s balance

sheet and do not take into account the liabilities Most common example of AO approach is Mean–variance optimization (MVO) which considers only the expected returns, risks, and correlations of the asset classes in the investment opportunity set

2 Liability-relative (LR) approaches: In LR approach, asset allocation considers both the risk

characteristics of the liabilities and assets This approach focuses on funding the liabilities This approach is also known as liability-driven investing (LDI) An example of LR approach is surplus optimization wherein the objective is to maximize growth of the surplus (value of the investor’s assets - present value of the investor’s liabilities) for a given level of risk to the surplus (or deficit) Another example is a liability-hedging portfolio which focuses on funding liabilities and, any

additional funds (also known as “return-seeking portfolio”) are invested in risky assets that can generate a return above and beyond the liability benchmark

3 Goals-based approaches: In goals-based approaches, asset allocations focus on addressing an

investor’s goals For this purpose, sub-portfolios of an investor, reflecting various goals ranging from supporting lifestyle needs to aspirational have their own specific asset allocation This approach is also known as Goals-based investing (GBI)

Distinctions between liabilities for an institutional investor and goals for an individual investor: Before

discussing the investment objectives of these three asset allocation approaches, it is important to understand distinctions between liabilities for an institutional investor and goals for an individual

investor

Institutional Investor Liabilities Individual Investor Goals

Legal obligations or debts; Goals, such as meeting lifestyle or aspirational

objectives, are not obligations;

Institutional liabilities, such as life insurer

obligations or pension benefit obligations, are

uniform in nature

An individual’s goals may be many and varied;

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

5.1 Relevant Objectives

This section addresses LO.c:

LO.c: Compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation

approaches;

Exhibit 5: Asset Allocation Approaches: Investment Objective

Asset Allocation Approach Relation to Economic

Balance Sheet Typical Objective

Typical Uses and Asset Owner Types

Asset only Ignore liabilities or investor’s

 Sovereign wealth funds

 Individual investors Liability-relative Takes into account legal and

quasi-liabilities

Fund liabilities to meet obligations and invest excess assets for growth

Use: focus on meeting liability obligations as the penalty for not meeting them is high

Asset owner types:

 Banks

 Defined benefit pensions

 Insurers

Goals based Takes into account investor’s

goals (or extended liabilities)

Achieve goals with specified required probabilities of success

Individual investors

5.2 Relevant Risk Concepts

This section addresses LO.d:

LO.d: Contrast concepts of risk relevant to asset-only, liability-relative, and goals-based asset allocation

approaches;

Asset Allocation Approaches: Investment Risk

Asset Allocation Approach Relation to Economic Balance Sheet Relevant Risk Concepts

Asset only Does not explicitly model liabilities or

goals

 Volatility (standard deviation) of portfolio return, which depend on asset class volatilities and correlation

 risk relative to benchmarks, e.g tracking risk or tracking error;

 downside risk, measures through semi-variance, peak-to- trough maximum drawdown, value-at- risk (VAR);

 Monte Carlo simulations, i.e we can change variables and analyze the impact on outcomes; Liability-relative Models legal and quasi-liabilities  Shortfall risk to measure whether assets are

sufficient to pay obligations when due;

 Risk limits: Maximum acceptable probability of not achieving a goal or minimum probabilities of failure (risk of failing to achieve goals);

 Overall portfolio risk is the weighted sum of the risks associated with each goal;

5.3 Modeling Asset Class Risk

An asset class can be defined as a set of assets that have similar characteristics, attributes, and

risk−return relationships

There are three broadly defined asset “super-classes”:

1) Capital assets: Capital assets provide a source of ongoing value (e.g interest or dividends) As a

result, these may be valued based on the net present value of their expected returns Equities and

fixed income are examples of capital assets

2) Consumable/transformable assets: Consumable/transformable asset is one that can be consumed

or transformed into another asset as part of a production process The value of a

consumable/transformable asset is based on its supply and demand Commodities (such as grains,

metals and energy products) are examples of consumable/transformable assets

3) Store of value assets: Store of value asset is one that does not generate cash flow and is not used as

an economic input Their economic value can only be realized through sale or transfer Art and

currencies are examples of store of value assets

Note: While these three asset super-classes are by definition distinct, the lines between them are blur in

real life as many assets contain characteristics of two or even (as in the case of gold) all three

definitions

Refer to Example 4 from the curriculum

This section addresses LO.e:

LO.e: explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification;

Criteria for asset class specification: For the purpose of asset allocation, we can specify the asset classes

using the following five criteria:

1 Homogeneous: Assets within an asset class should be relatively homogeneous, which means they

should have similar attributes Example: Common Stocks and Equities

2 Mutually exclusive: Asset classes should be mutually exclusive, which means they should not be

overlapping Example: if one asset class for a US investor is domestic common equities, then world equities ex-US is more appropriate as another asset class rather than global equities, which include

US equities

3 Diversifying: Asset classes should be diversifying, which means that the included asset class should

not have extremely high expected correlations with other asset classes or with a linear combination

of other asset classes For this purpose, it is preferable to assess return series’ correlations during times of financial market stress

4 Investable Wealth: The asset classes as a group should make up a majority of world investable

wealth In other words, the asset classes should be exhaustive (include everything)

5 Portfolio’s Liquidity: Asset classes selected for investment should have the capacity to absorb a

significant proportion of an investor’s portfolio without seriously affecting the portfolio’s liquidity

Asset Classes in Practice: A typical list of asset classes includes the following

 Global public equity—composed of developed, emerging, and sometimes frontier markets and

large-, mid-, and small-cap asset classes; can be further divided by several sub-asset classes (e.g., domestic and non-domestic)

 Global private equity—includes venture capital, growth capital, and leveraged buyouts (investment

in special situations and distressed securities)

 Global fixed income—includes developed and emerging market debt and further divided into

sovereign, investment-grade, and high-yield sub-asset classes, cash and short-duration securities and sometimes inflation-linked bonds (unless included in real assets as mentioned below)

 Real assets—include assets that provide sensitivity to inflation, such as private real estate equity,

private infrastructure, commodities, and sometimes global inflation-linked bonds

It is pertinent to note that hedge funds are not an asset class Hedge funds encompass a wide variety of investment strategies and through these different strategies, they invest in traditional asset classes, such as equity, debt, property, commodities and cash Therefore, hedge funds should be treated as a category called “strategies” or “diversifying strategies.” Unlike strategies, asset classes generally provide

an inherent, non-skill-based ex ante expected return premium

Refer to exhibit 6 below, reflecting examples of asset classes and sub-asset classes Sub-asset class choices become relevant when the investor moves from the strategic asset allocation phase to policy implementation

Source: CFA Curriculum

To achieve a diversified portfolio, it is preferred to use broadly defined asset classes with fewer risk source overlaps, e.g US and non-US equity asset classes would have fewer overlap in the sources of risk

as compared to US large-cap equity and US small-cap equity

Refer to Example 5 from the curriculum

This section addresses LO.f:

LO.f: explain the use of risk-factors in asset allocation and their relation to traditional asset class – based approaches;

In mean–variance optimization, asset allocation is based on asset classes (e.g., global public equity, global private equity, global fixed income, and real assets) taking into account their expected return, return volatility, and return correlation estimates The drawback of using asset classes as the unit of analysis in asset allocation is that it may result in portfolio’s sensitivity to overlapping risk factors For example, in Exhibit 7 below, we can observe that even broadly defined asset classes (that is, US equity and US Corporate Bonds) have some common risk factor exposures, such as both asset classes are exposed to currency risk, inflation, etc However, some factor exposures are not common between two asset classes, such as, unlike US Corporate Bonds, US Equity is exposed to GDP growth Due to common factor exposures, the correlation between these two asset classes is not zero

Source: CFA Curriculum

In contrast, in factor-based approaches, asset allocations are based on risk factors and the desired exposure to each factor and thus, asset classes are described with respect to their sensitivities to each of the risk factors

Factor Representation: The following are a few examples of how risk factor exposures can be

achieved

 Inflation The inflation component can be isolated by going long nominal Treasuries and short inflation-linked bonds

 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 Credit exposure can be isolated by going long high-quality credit and short

Treasuries/government bonds

 Duration Duration exposure can be isolated by going long 10+ year Treasuries and short 1–3 year Treasuries

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 For example, if an investor’s goal is focused on inflation, then simply investing in equities or bonds will not satisfy this goal In this case, a portfolio needs to be created that is

focused on this particular risk factor

 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 This implies that factor models become important if an investment manager is not willing to take exposure to all the risk factors associated with, say US Equities, and wants to focus on particular risk factor

 The acknowledgment that many highly correlated so-called asset classes are better defined as parts

of the same high-level asset class In other words, some investors might define US Equities and Non

US Equities as different asset classes but considering the risk factors associated with these two asset classes, it would be more appropriate to treat them as part of the same asset class, that is, global equity

 The realization that equity risk can be the dominant risk exposure even in a seemingly

well-diversified portfolio

6 STRATEGIC ASSET ALLOCATION

Strategic asset allocation or policy allocation: Asset allocation that is expected to be effective in achieving investment objectives given investment constraints and risk tolerance

Optimal asset allocation maximizes utility of ending wealth subject to constraints

Steps of selecting a strategic asset allocation: Selecting a strategic asset allocation involves the

following steps:

1 Formulate the investor’s objectives (in quantitative terms)

2 Formulate the investors risk tolerance (in quantitative terms)

3 Determine the investment horizon(s)

4 Determine constraints that may impact asset allocation choices

5 Determine most suitable approach to asset allocation (i.e AO, LR, GB) for the investor

6 Specify asset classes, and develop a set of capital market expectations for the specified asset classes

7 Develop a range of potential asset allocation choices for further consideration

8 Evaluate the potential results in relation to investment objectives and risk tolerance over

appropriate planning horizon(s) for the different asset allocations developed in Step 7 as well as the sensitivity of the outcomes to changes in capital market expectations

9 Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed

This section addresses LO.g:

LO.g: select and justify an asset allocation based on an investor’s objectives and constraints;

Example: GPFC, A Sovereign Wealth Fund

The emerging country of Cafastan has established a sovereign wealth fund (name: Government

Petroleum Fund of Cafastan (GPFC)) to earn revenue from its abundant petroleum reserves The details are as under:

 Tax status: Non-taxable

 Refer to exhibit 8 below, reflecting Economic Balance Sheet of GPFC

Source: CFA Curriculum

Before selecting an appropriate asset allocation for GPFC, it is important to consider the following:

 Promote a fair sharing of the benefits between current and future generations;

 The amount and timing of funds needed for future distributions to Cafastan citizens are, as yet, not clear

 Diversification across global asset classes;

 Correlations with the petroleum sources of income to GPFC;

 The potential positive correlation of future spending with inflation and population growth in

Cafastan;

 Long investment horizon and no liquidity needs;

 return outcomes in severe financial market downturns

Risk tolerance: GPFC is willing to bear volatility of up to 17% and a 5% chance of losing 22% or more of portfolio value in a given year This risk is evaluated by examining the one-year 5% VaR of potential asset allocations

Evaluate the following current strategic asset allocation of GPFC and the three alternatives to determine which asset mix can provide an incremental improvement on the current asset allocation

Source: CFA Curriculum

Alternative Pros Cons Decision

Mix A  10% allocation to diversifying strategies does not

pose liquidity risk owing to GPFC’s long investment horizon and absence of liquidity needs

 Lower allocation to private real estate (10% v/s 20%

current) would improve overall liquidity profile of the fund

 lower volatility (14.2%) than the current allocation (15.57%)

 Lower tail risk (VaR −15%) against VaR of -17% for the current asset mix

 Higher Sharpe ratio compared with current asset mix.

Since real estate is illiquid, it could be difficult to reallocate from real estate to diversifying strategies

in short time

Should be considered as it provides an incremental improvement on the current asset allocation

Mix B  Higher allocation to equities and lower allocation to

bonds and diversifying strategies in relation to Mix A may result in higher expected return

 VaR (-18.5%) is > in relation with current mix and mix

A but within GPFC’s tolerance of 22%

Lower Sharpe ratio (0.353) in comparison with current mix and mix A – indicating that this mix makes inefficient use of its additional risk

Should not be considered as

it does not provide incremental improvement

Mix C  Higher allocation to equities (55%) – potential for

higher expected return and providing exposure to such a factor as a GDP growth factor

 More diversified mix, reflected by 25% allocation in non-domestic equities

 Fixed-income allocation has been diversified with an exposure to both nominal and inflation-linked bonds – providing hedge against inflation risk inherent in future distributions

 Reduced weight in real estate (illiquid in nature)

 Lowest volatility and the lowest VaR among the asset mixes

 Sharpe ratio is slightly or insignificantly higher than Mix A’s.

Should be considered as it has edge over other asset mixes

Refer to Example 6 from the curriculum

Global Market Portfolio

This section addresses LO.h:

LO.h: describe the use of the global market portfolio as a baseline portfolio in asset allocation;

The global market portfolio (GMP) represents the global market for investable asset classes broken down by their share of the global market The global market-value weighted portfolio can be considered

as a baseline asset allocation According to the two-fund separation theorem, all investors optimally hold a combination of a risk-free asset and an optimal portfolio of all risky assets This optimal portfolio

is the global market value portfolio

Investing in the global market portfolio is done in two steps, i.e

i Step 1: The assets are allocated in the portfolio in proportion to the global portfolio of stocks,

bonds, and real assets

ii Step 2: Each of these broad asset classes are broken down into regional, country, and security weights using capitalization weights

Most commonly used proxy for a global market portfolio is an exchange-traded fund (ETF) Investors can deviate from global portfolio by e.g overweighting the home-country market, value, size (small cap), and emerging markets

Implementation hurdles in investing in a global market portfolio:

1) Size of each asset class on a global basis cannot be precisely determined due to uneven availability

of information on non-publicly traded assets

2) It is practically difficult to invest proportionately in residential real estate

3) Private commercial real estate and global private equity assets cannot be easily carved into portions that is accessible to most investors

 Tax status: Non-taxable

 Capital market assumptions indicate that equities have a significantly higher expected return and volatility than fixed income

 Exhibit 10 below shows the economic balance sheet of GPLE

Source: CFA Curriculum

 Factor to consider for choosing asset allocation: Pensioners want to receive the stream of promised benefits with as little risk, or chance of interruption, as possible;

GPLE, the plan sponsor, receives two asset allocation recommendations, as explained below

Recommendation Description Asset allocation Pros Cons

Recommendation A does not explicitly

consider GPLE’s pension’s liabilities; based on

an asset-only approach;

65% allocation to global equities and a 35% allocation to global fixed income;

 This asset allocation is mean–variance efficient and has the highest Sharpe ratio

 may increase the size of the buffer between pension assets and liabilities

However, it is important to know that any increase in buffer would not benefit the sponsors if the current buffer

is adequate

 Subject to contribution risk for the plan, because with a 0.65 × $1.25 billion = $0.8125 allocation to equities and a current buffer

of assets of $1.25 billion – $1.087 billion

= $0.163 billion, a decline of that amount or more in equity values (a 20% decline) would make the plan status into underfunded;

Recommendation B explicitly consider

liabilities by incorporating a liability-hedging portfolio;

 $1.125 billion or 90% allocation to a fixed-income portfolio, i.e equal

to present value of plan liabilities (liability hedging portfolio);

 a $0.125 or 10%

allocation to equities (the return-seeking portfolio)

 No substantial contribution risk because the risk characteristics of the $1.125 billion fixed-income portfolio are closely matched with those of the

$1.087 billion of pension liabilities with a buffer;

 lies below the asset-only efficient frontier with a

considerably lower expected return vis-à- vis Recommendation A;

Conclusion: Since interest rates are a major financial market driver of both liability and bond values, the

LR approaches put more weight to fixed income in asset allocation, for frozen DB in particular) In case

of underfunded plans, the potential upside of equities may have greater value for the plan sponsor than

in the fully funded case that we examined

Liability Glide Paths: A liability glide path is a technique which is used for underfunded plans In this

technique, the plan sponsor specifies in advance the desired proportion of liability-hedging assets and return-seeking assets and the duration of the liability hedge as funded status changes and contributions are made This technique helps in increasing the funded status by reducing surplus risk over time

6.3 Goals Based

As goals-based asset allocation has advanced, various classification systems for goals have been

proposed Two of those classification systems are as follows