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

The Economic Balance Sheet and Implication for Asset Allocation• An economic balance sheet includes: ▪ Conventional financial assets and liabilities ▪ Extended portfolio assets and lia

Level III

Introduction to Asset Allocation

Summary

Elements of Effective Investment Governance and Investment

Governance Considerations in Asset Allocation

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

The Economic Balance Sheet and Implication for 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

Investment Objectives of Asset-Only, Liability-Relative

and Goals-Based Asset Allocation Approaches

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

• Individual investors

Liability relative Models legal and

quasi-liabilities

Fund liabilities and invest excess assets for growth

Penalty for not meeting liabilities high

• Banks

• Defined benefit pensions

• Insurers

Goals based Models goals Achieve goals with specified

required probabilities of success

Individual investors

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

Use of Asset Classes to Represent Exposure to Systematic Risk and Criteria for Asset Class Specification

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.”

Criteria for Asset Class Specification

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

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)

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

Use of Risk Factors in Asset Allocation and their Relation to

Traditional Asset Class-Based Approaches

At times an investor’s goals and objectives cannot be met through traditional asset classes

Risk factor approaches to asset allocation focus on assigning investments to the investor’s desired exposures to specified risk factors

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

Bonds

Select and Justify an Asset Allocation Based on Objectives and Constraints

GPFC Sovereign Wealth Fund

• Consideration: 1) Expected return in relation to volatility 2) volatility and 3) VaR

GPLE DB Pension Plan

• Plan assets = 1.25 billion; PV of pension obligations = 1.087 billion

Lee Family

Asset Allocation

Approach Typical Uses and Asset Owner Types

Asset only Liabilities or goals not defined and/or simplicity is important

Suitable for: some foundations, endowments, sovereign wealth funds, individual investors

Liability relative Penalty for not meeting liabilities high

Suitable for: banks, defined benefit pensions, insurers

Goals based Suitable for some individual investors

Use of Global Market Portfolio as Baseline Portfolio in Asset

Allocation

Global market-value weighted portfolio should be the baseline asset allocation

• Represents all investable assets  minimizes non-diversifiable risk

• Investing in the global market portfolio helps mitigate investment biases such as home country bias

Investing in the global market portfolio is done in two phases:

• Allocate assets in proportion to the global portfolio of stocks, bonds, and real assets

• Disaggregate each broad asset class into regional, country, and security weights using capitalization weights

Implementation hurdles:

• Size of each asset class on a global basis can’t be precisely determined

• Not practical to invest proportionately in residential real estate

• Private commercial real estate and global private equity assets are not easily carved into pieces of a size that is accessible to most investors

Proxies for the global market portfolio are often based only on traded assets, such as portfolios of exchange-traded

Strategic Implementation Choices in Asset Allocation

• Passive/active management of asset class weights

▪ Passive strategy: stick to strategic asset allocation (SAA)

▪ Active strategy: allow deviation from SAA

➢Called tactical asset allocation (TAA)

• Passive/active management of allocations to asset classes

▪ Passive strategy: each asset class based on relevant benchmark

▪ Active strategy: deviate from asset class benchmark

• Risk budgeting: which risks to take and to what extent

▪ Can be stated in absolute or relative terms

▪ Active risk budgeting: how much benchmark-relative risk an investor is willing to

take in seeking to outperform a benchmark; two levels of active risk budgeting

➢ Overall asset allocation level

➢ Individual asset class level

Factors impacting active vs passive investment decision:

• Available investments

• Scalability of active strategies being considered

• Feasibility of investing passively given constraints

• Beliefs concerning market informational efficiency

• Cost-benefit trade-off

• Tax status

Strategic Considerations in Rebalancing Asset Allocations

Rebalancing: discipline of adjusting portfolio weights to more closely align with the strategic asset allocation Without rebalancing the overall portfolio risk rises

IPS should specify rebalancing policy and who is responsible for rebalancing

Calendar rebalancing versus percent-range rebalancing

▪ How frequently is the portfolio valued?

▪ What size deviation triggers rebalancing?

▪ Is the deviation from the target allocation fully or partially corrected?

• Higher transaction costs for an asset class imply wider rebalancing ranges

• More risk-averse investors will have tighter rebalancing ranges

• Less correlated assets have tighter rebalancing ranges

• Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion encourages tighter ranges

• Illiquid investments complicate rebalancing

• Derivatives create the possibility of synthetic rebalancing