CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r18 asset allocation with real world constraints summary

Asset size: a portfolio could be: • too large for some asset classes and certain active strategies • too small for complex asset classes like hedge funds and private equity and where

Level III

Asset Allocation with Real-World Constraints

Summary

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Constraints in Asset Allocation

In the real world the investment opportunity set is influenced by

several constraints

Asset size: a portfolio could be:

• too large for some asset classes

and certain active strategies

• too small for complex asset classes

like hedge funds and private equity

and where there is a minimum

investment requirement

Liquidity constraint has two dimensions:

Liquidity characteristics of asset class

Liquidity needs of asset owner

• Time horizon

• Liquidity needs under high market stress

• Governance capacity

Regulatory and Other External Constraints

• Allocations to certain asset classes might

be constrained by regulator

• Tax incentives

• Need to maintain certain financial ratios

Time horizon Two major aspects:

• Changes in human capital

• Changing character of liabilities

After-Tax Portfolio Optimization

Portfolio optimization should be based on after-tax

return and risk

• r at = r pt (1 – t) or r at = p d r pt (1 – t d ) + p a r pt (1 – t cg)

• σat = σpt (1 – t)

• Correlations are not impacted by taxes

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

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

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

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

▪ Business conditions

▪ Investor’s circumstances

• 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

Glide path: anticipate changes in risk

appetite and implement pre-established changes to asset allocation in response.

Short-Term Shifts in Asset Allocation

Tactical asset allocation (TAA) allows short-term deviations from SAA based on cyclic variations and

temporary price dislocations in capital markets

• TAA assumes that returns in the short-run are predictable

• Success of TAA decisions should be evaluated

▪ Compare Sharpe ratio realized under the TAA with Sharpe ratio under SAA

▪ Evaluate information ratio

▪ Plot the realized return/risk of the TAA versus the realized return of SAA’s efficient frontier

• Downside of TAA: higher trading costs, higher taxes and higher concentration of risk relative to

policy portfolio

Discretionary TAA is based on manager skill in predicting short-term market movements and considers,

large number of data points such as valuations, credit spreads, monetary and fiscal policy, GDP growth, economic sentiment indicators, market sentiment indicators, etc

Systematic TAA seeks to exploit asset class level return anomalies that have been shown to have some

predictability and persistence such as value factor and momentum factor

Bias Implication Mitigation

Representativeness Bias

Overweight importance of most

recent observations and

information (recency bias).

Return chasing  overweight in asset classes which have

performed well recently.

Objective asset allocation process and strong governance framework

Availability Bias

People take a mental shortcut

when estimating the probability of

an outcome based on how easily

the outcome comes to mind.

Outcomes that come to mind easily are considered more likely.

Familiarity Bias Home Bias

Use global market portfolio as starting point

Strong governance framework.

Framing Bias

Answer question differently based

solely on how it is asked (framed).

Investor’s choice of asset allocation may be influenced by the manner in which the risk-return tradeoff is presented

Present possible asset allocation choices with multiple perspectives

on risk/reward trade-off; present risk in terms of shortfall

probability, VaR, CVaR, etc.

Dealing with Behavioral Biases in Asset Allocation

Bias Implication Mitigation

Loss Aversion

People dislike losses more than

they like gains; prefer avoiding

losses over achieving gains.

Might interfere with ability to maintain chosen asset allocation during periods of negative returns.

Goal-based investing:

Frame risks in terms of shortfall probability.

Fund high-priority goals with low-risk assets.

Illusion of Control

Tendency to overestimate one’s

ability to control events based on

superior knowledge, skills and/or

resources

Exacerbated by overconfidence

and hindsight biases.

Alpha-seeking behavior Excessive trading

Concentrated positions Underexposure to asset classes which are a significant part of the global market portfolio

Use global market portfolio as starting point in developing global asset allocation.

Formal asset allocation process based on long-term forecasts.

Mental Accounting

Treat one some of money

differently from another sum

based on the mental account the

money is assigned to.

Failure to consider correlations between assets assigned to different mental accounts  suboptimal overall portfolio.

Goals-based investing; if each sub-portfolio is on the same efficient frontier  optimal overall

portfolio.