Cfa Level Iii - Study Session 8

Front 1

Asset Allocation

What is the strategic asset allocation part of portfolio management?

(SS8)

Back 1

Strategic asset allocation comes in at the planning step. It considers the individuals:
i. Return objectives
ii. Risk tolerance
iii. investment constraints
iv. Long-run capital market expectations.

After this process you have a set of WEIGHTS telling you how much to invest in each asset class.
These weights = POLICY pf
= strategic asset allocation

Front 2

Asset Allocation

What is the difference between strategic and tactical asset allocation?

(SS8)

Back 2

Strategic Asset Allocation
i. 5 year plan
ii. Initial permissions to invest a % of the portfolio in a particular asset class.
iii. Gives target weights and a 'permissible range' either side. The range of allowable weights is your risk management device.
iv. Systematic risk is rewarded and strategic asset allocation specifies the investors desired exposures to systematic risk.
v. Strategic sets the investors chosen exposures to long-term systematic risk.

Tactical Asset Allocation
i. Makes short term adjustments to weights
ii. Looks for opportunities in assets where they perform relatively better in the short term
iii. 1-3 months. It gives ACTIVE risk

Front 3

Asset Allocation

How is asset allocation important for portfolio performance?

(SS8)

Back 3

How much of returns over time are attributable to asset allocation (and thus strategic)
1. Studies show that 93.6% of returns are due to asset allocations
2. Timing and security selection contribute the other 6.4%
3. Studies show active return to be negative which suggests that you can't time the market.

Front 4

Asset Allocation

What is AO approach vs ALM?

(SS8)

Back 4

Asset Only
i. No liability modeling
ii. Less controlling of risk compared to ALM
iii. Black Litterman model - where global market pf is the strategic asset allocation
iv. Absolute risk for absolute return is associated with AO

Asset Liability Management
i. Models liabilities
ii. uses asset allocation to fund liabilities (DB plans). Have higher levels of fixed income asset allocations.
iii. Individual investors (non-DB plans) can view their future income requirements as liabilities. Quasi-liabilities
iv. Penalties are involved for not covering liability
v. CF matching, immunisation min risk in respect to surplus
Deliberate risk for higher expected surplus

Front 5

Asset Allocation

What is the difference between STATIC and DYNAMIC asset management?

(SS8)

Back 5

Static Asset Management
i. Doesn't link optimal asset allocation decisions at different time periods

Dynamic Asset Management
i. Changes over time from period to period.
ii. Asset allocation is related to optimal investment decisions at all future time periods.
iii. ADV: Dynamic is that it applies to BOTH AO and ALM perspectives.
iv. Disadvantage of dynamic is that it is costly and time consuming to implement
v. Funds and DB plans still find dynamic worth the time if they have big liabilities.

Front 6

Asset Allocation

Return Objectives
(SS8)

Back 6

1. Real required rate +
2. Inflation +
3. Cost to earn returns
(1.05)(1.03)(1.0045) - 1 = 8.63%

Use additive rates as an approximation
i. It's ok for low levels of spending

Use multiplicative
i. For strategic asset allocation
ii. Better for compounding returns because you need to know the higher rate

Front 7

Asset Allocation

Risk Objectives for strategic asset allocation (risk aversion Ra)
(SS8)

Back 7

1.
U = E(Rm) - 0.005Ra O2m
i. Utility equals expected return less a risk penalty based on their risk aversion
ii. Remember to use variance which is sd squared for the risk penalty term.

2. Shortfall risk (a part of downside risk)
Roy's Safety First Criterion
= E(R) - R..
-----------------
o
= expected return above the shortfall level divided by the sd.
i. If your R.. is less than the rf rate then you just have to hold the risk free asset to avoid the chance that the threshold return isn't met.

Front 8

Asset Allocation

Criteria for making an Asset Class
(SS8)

Back 8

1. Homogeneous - high correlations to within class assets (don't lump real estate with common stock)
2. Mutually exclusive (any overlap double counts and reduces your ability to control risk)
3. Asset classes should be diversifying ( < 0.95 correlation)
4. Sum of asset classes should get close to the worlds wealth
5. Asset class should be able to absorb big trades (i.e. not have high transaction costs and give the investor the ability to rebalance)

Front 9

Asset Allocation

Traditional Asset Class
(SS8)

Back 9

1. Domestic common equity
2. Domestic fixed income
3. Non-domestic (international) common equity
4. Non-domestic fixed income
5. Real estate
6. Cash and cash equivalents

Not every asset class is for everyone. If you are tax-exempt then you don't want tax-exempt bonds in your asset class.
If you aren't a zillionaire then you don't want private equity as an asset class.

It's all about - can you improve your existing portfolio by adding an asset class. You only add an asset class if it INCREASES the Sharpe ratio.

NB: It doesn't tell you how much to add though.

Front 10

Asset Allocation

Example:
Should you add the asset class?
(SS8)

Back 10

The portfolio has a Sharpe ratio of 0.15. Schmidt is considering adding US equities to the existing portfolio. US equities as represented by Russell 3000 Index have a Sharpe of 0.18.
The predicted correlation with the existing is 0.7. Should it be added?

Sharpe existing x corr =
(0.15)(0.7) = 0.105
The foundation should add U.S Equities if their predicted Sharpe ratio exceeds 0.105. Because Schmidt predicts a Sharpe of 0.18 for US equities the foundation SHOULD add them to the portfolio
0.18 > 0.105

NB: If the distribution of the proposed asset class's returns is pronouncedly non-normal, then this criterion is not applicable.

Front 11

Asset Allocation

Where does the home country bias come from?
(SS8)

Back 11

1. Currency risk - hedge it? or love it unhedged?
2. Increased correlations in times of stress - lose some of their diversification benefits just when you need them
3. Emerging market concerns - limited free float of shares

Lack of familiarity with nondomestic markets

Front 12

Asset Allocation

Should alternative investments be lumped together in the same asset class?
(SS8)

Back 12

Real estate, hedge funds, natural resources are too heterogeneous to be considered as one asset class.

i. some investors have a resource constraint limiting investment in alternative assets
ii. fees and expenses are often steep for alternative assets.

Front 13

Asset Allocation

What parts of Asset Allocation never change?
(SS8)

Back 13

1. Optimizer
2. Prediction Procedure
3. Investor's Risk Tolerance Function

Front 14

Asset Allocation

What parts of Asset Allocation are always changing?
(SS8)

Back 14

1. Capital Market Conditions
2. Investor's Assets, Liabilities, Net Worth
3. Investor's Risk Tolerance (note, the FUNCTION can change, the tolerance doesn't have to)
4. Expected returns, risk
5. Optimal asset mix can change OPTIMIZER does not

Front 15

Asset Allocation

How is the unconstrained MVF different to sign-constrained?
(SS8)

Back 15

Unconstrained
i. can have negative weights

Constrained
i. has to have positive weights (non-negative, no shorting)
ii. sum to 1
iii. Corner portfolios come in here where each corner is where on of the assets shifts from a 0 weight or to a 0 weight. Corner's are all about optimisation.

Front 16

Asset Allocation

Why is the corner portfolio approach flawed?
(SS8)

Back 16

Corner portfolio optimisation is flawed because it is:
1. So dependent on inputs
2. Highly sensitive to small changes in inputs
3. Therefore susceptible to estimation error.
4. Most important inputs are RETURNS, if you get those even a little bit wrong it throws everything out.

Front 17

Asset Allocation

What are they going to ask you with the corner portfolios?

(SS8)

Back 17

Once you have the weights, they ask you to justify it
i. is efficient (i.e. it lies on the efficient frontier)
ii. is expected to satisfy his return requirement (in this example 8.5%)
iii. it is expected to meet his risk objective
iv. has the highest expected Sharpe ratio
v. is the most consistent with the IPS statement concerning minimising losses within any one investment type.

Front 18

Asset Allocation

Example - If they say 'Determine the most appropriate strategic asset allocation if the trustee wants to MINIMISE S.D of return subject to a return objective?
What to do?

(SS8)

Back 18

1. Take the corner portfolio with the best Sharpe
2. Match it with the treasury bill they give in the question. They will say
Note: Risk-free rate = 2.3%
6.5 = 7.24w + 2.3 (1 - w)
3. Now you have a weight in ONE corner pf and then a weight in the rf asset
4. New expected return should MATCH your return requirement
5. New standard dev should be below the corner pf
6. Sharpe ratio HAS NOT changed. The pf with the treasury bill should still have the same Sharpe as corner pf4

Front 19

Asset Allocation

Resampled Efficient Frontier
(Advantages vs Disadvantages)
(SS8)

Back 19

Disadvantages MVO:
1. Inputs are difficult to predict
2. Small changes in inputs create big changes in outcomes

Resampled efficient frontier:
ADVANTAGES
1. More stable through time than those on a conventional mean-variance efficient frontier from a single optimisation.
2. More diversified than those on a conventional mean-variance efficient frontier from a single optimisation.

Resampled Efficient Frontier:
DISADVANTAGES
1. Lack of theoretical underpinning
2. Relevance of historical return frequency data to current asset market values

Front 20

Asset Allocation

Black Litterman
(deals with estimation error of expected returns)
(SS8)

Back 20

Unconstrained Black Litterman
1. Using starting point asset weights based on MSCI World pf.
Good because being anchored to estimates means that they are more consistent.
2. Good because it uses historical actual data
3. Assumes market pf based weights are optimal (i.e. from MSCI)
4. Goal is to create stable, mean-variance-efficient portfolios which overcome the problem of expected return sensitivity

BL Model - reverse engineers
1. Starts with the investors opinions on returns as a starting point
2. Takes the weights from the MSCI or market portfolio (instead of the other way around having the returns first and then calculating the weights as in MVO)

Front 21

Asset Allocation

Asset Allocation for an Investor with No Views
(SS8)

Back 21

John has no views about future asset returns and an average risk tolerance. What would be his optimal asset allocation?
Answer: According to Black-Litterman, he should invest in 5 asset clases in the proportional market-value weights.
57% Americas
6% Asia ex Japan
17% Europe/Africa ex UK
10% Japan
10% UK

What if the investor has below average risk tolerance
Answer: Combine that portfolio with market weights with a risk-free asset to lower the overall risk.
ie Market portfolio is still optimal for him.

Front 22

Asset Allocation

Monte Carlo
(SS8)

Back 22

Shoots out outcomes from particular strategic allocations under random scenarios for investment returns, inflation and other variables
1. Gives a range of outcomes
2. Gives a likelihood that each result will occur.

Front 23

Asset Allocation

Asset/Liability Management
(SS8)

Back 23

1. ALM perspective focuses on the surplus efficient frontier
2. Mean-variance surplus optimisation extends traditional MVO to incorporate the investor's liabilities
3. Has a 'surplus beta decision'
4. Left-most point is the MSV minimum surplus variance - the pf with the least risk from an ALM perspective. This point would be a cash flow match strategy or immunisation.
5. People who like more risk might choose somewhere to the right where a greater amount of surplus risk leads to a greater ending surplus.

Front 24

Asset Allocation

Asset/Liability Management
What happens when you have a negative surplus?
(SS8)

Back 24

If you have a negative surplus, say 80% funded
1. You are underfunded
2. You have positive risk (because you have a negative expected surplus)
3. Pension plan sponsor will have to make additional contributions in the future to make up the funding shortfall.

Front 25

Asset Allocation

Experience-Based Approaches
(SS8)

Back 25

1. A 60/40 stock/bond asset allocation is a good starting point for an average investor's asset allocation
2. The allocation to bonds should increase with increasing risk aversion.
3. Investors with longer time horizons should increase their allocation to stocks.
4. A rule of thumb for the percentage allocation to equities is 100 minus the age of the investor.

Front 26

Asset Allocation

Implementing the Strategic Asset Allocation
(SS8)

Back 26

1. Passive
i. tracking portfolio of cash market securities
ii. derivatives-based pf, with a cash position plus a long position in a swap.
iii. derivatives based pf, with a cash position plus a long position in index futures for the asset class
2. Active
i. pf of cash market securities reflecting the investors perceived insights, with no attempt to track
ii. a derivatives-based position to provide a commodity-like exposure to the asset class plus a market neutral long-short position to reflect the active investment ideas.
3. Semiactive investing
i. tracking pf of some under or over-weighting of securities relative to asset class index but with controlled tracking risk
ii. derivatives based position in asset class plus controlled active risk in the cash position (such as actively managing its duration)
4.

Front 27

sset Allocation

Rebalancing to the Strategic Asset Allocation
(SS8)

Back 27

1. Done on a calendar year
i. less good at controlling risk than rebalancing on a % basis.
2. Done on a % basis i.e. when weights go outside threshold
i. done on weights isa the better one when controlling risk

Front 28

Asset Allocation

Asset Allocation and Human Capital
(SS8)

Back 28

Theory of asset allocation says:
1. Ignoring human capital, maintain constant pf weights throughout life
2. Considering human capital, change asset allocation depending on what your life is and which stage you're at

i. Investors with sage labor income (thus safe human capital) will invest more of their financial portfolio into equities. Tenured professor vs at-will employee
ii. Investors with labor income that is highly positively correlated with stock markets should tend to choose an asset allocation with less exposure to stocks. E.g. stockbroker
iii. Ability to adjust labor supply (high labor flexibility) tends to increase an investor's optimal allocation to equities. Labor flexibility functions like a kind of insurance against adverse investment outcomes. Working longer, or retiring later.
If human capital is risk free, an all equity portfolio is optimal.

Human capital is effectively like a bond.

Front 29

Asset Allocation

for Mortality and Longevity risk
(SS8)

Back 29

1. Mortality risk - use life insurance
i. borne by family
2. Longevity risk - buy an annuity
i. borne by individual, you cop the issues of running out of money yourself.
ii. exposure to longevity risk offers no reward for bearing the risk
iii. annuities spread this risk across multiple investors

Life Annuity types
i. fixed annuity - periodic payments are fixed in amount
ii. variable annuity - payments depend on underlying investment returns
iii. equity-indexed annuity - includes some participation in the stock market. This is a risk-free asset plus a call option on stock returns.

Annuity choice is separate from strategic asset allocation.

Front 30

Asset Allocation

Strategic asset allocation for institutional investors
(SS8)

Back 30

Defined-benefit plans
1. Regulatory constraints - prudent man concept, regulatory min in cash lets say or max in domestic securities
2. Liquidity constraints
i. For ALM
- risk of funding shortfalls is acceptable
- volatility of pension surplus is acceptable
- volatility of the contributions is acceptable
ii. For Asset only AO
- lowest sd of return that meets the return objective of the pension fund.

Front 31

Asset Allocation

Example - Foundation IPS
(SS8)

Back 31

Objectives -
i. Return requirement - to cover inflation adjusted spending
ii. Risk tolerance - long time horizon?
Constraints -
i. Liquidity requirements - when does the cash have to be paid out
ii. Time horizon - foundations have a potentially infinite time horizon
iii. Tax considerations - maintain tax exempt status
iv. Legal and regulatory considerations - prudent person standards
v. Unique circumstances - chief donors? any substantial positions that you HAVE to hold?

Front 32

Asset Allocation

for Insurers
(SS8)

Back 32

1. Insurers are TAXABLE so focus on after-tax returns.
Insurers are major purchasers of tax-exempt bonds.
2. Insurers have contractual obligations to the insured.
3. Most insurers PORTFOLIO SEGMENT to split risks, some for life insurance, other investments designed to cover casualty insurance which would have shorter duration.
4. Insurers still hold equity as well, because they want to achieve surplus growth.

Front 33

Asset Allocation

for Banks
(SS8)

Back 33

Banks traditional focus is on taking deposits and lending money.
1. They are taxable and buy mostly short-term and intermediate term liabilities.
2. They want to MANAGE BALANCE SHEET overall interest rate risk. This is the MOST important goal.
3. They want to manage liquidity, having cash available to meet liabilities.
4. They want to produce income
5. They want to manage credit risk

Front 34

Asset Allocation

Tactical Asset Allocation
(SS8)

Back 34

TAA deliberately under or overweights asset classes
1. Relative to target weights in the policy portfolio to try and add value.
2. TAA is active management at the asset-class level (not individual security level)
3. TAA is all about short-term expectations (things out of whack/equilibrium)
4. TAA has to overcome a transaction costs barrier to be advantageous.
5. Relative to strategic asset allocation TAA is a source of tracking risk.

TAA thinks:
i. Market prices tell explicityly what returns are available
ii. Relative expected returns reflect relative risk perceptions. Tie in equity risk premium here, because it's relative risk of global markets.
iii. Markets are rational and mean reverting.
That said, things don't always mean revert. Sometimes anomalies persist or the investing environment has permanently changed.

Front 35

International Diversification

What happens when you add internationals to a domestic and fixed-income portfolio?
(SS8)

Back 35

Two motivations for international diversification
1. All else equal a low international correlation allows reduction of the volatility or total risk of a global pf
2. A low correlation also provides profit opportunities for an active investor.

i. Adding internationals reduces risk because the corr <1.

Front 36

International Diversification

What does international diversification do to the efficient frontier?
(SS8)

Back 36

1. It shifts the efficient frontier to the left
2. Lower risks for a given level of return
3. Higher return for a given level of risk
4. The domestic-only frontier is more constrained and the international frontier DOMINATES.

Front 37

International Diversification

Performance Benefits?
Risk-reduction benefits?
(SS8)

Back 37

Performance Benefits
i. More options to choose from
ii. more efficient 'frontier'
iii. higher/same returns for a lower level of risk
Risk-reduction benefits
i. as long as the correlation isn't large, it can lead to a reduction of total risk.
ii. hedged vs unhedged returns does nothing to the correlation numbers, therefore there are still diversification benefits.
iii. addition international lowers risk, but for the SAME return. If you were to just lower risk with a rf, you would also be lowering the return.
iv. International diversification takes away some of the nonsystematic volatility without sacrificing the expected return.
v. Global investing should increase the Sharpe ratio

Front 38

International Diversification

Explain why currency risk should NOT be a significant barrier to international investment.
(SS8)

Back 38

1. Currency risk may only slightly magnify the volatility of a foreign currency.
2. This is because market and currency risks are NOT additive.
3. Currency risk can be HEDGED for major currencies by selling futures or forward currency contracts, buying put currency options or borrowing foreign currency to finance the investment.
SO currency risk can be eliminated in international investment strategies.
4. This is because the contribution of currency risk should be measured for the total portfolio rather than individual markets or securities.
5. Currency risk decreases over longer time horizons. Exchange rates revert to fundamentals over the long run (mean reversion)
6. Currency risk is more important for bond investors than equity investments.
Currency risk for stocks is LOW
Currency risk for bonds is HIGH

Front 39

International Diversification

What are the barriers to international investment?
(SS8)

Back 39

Physical barriers
i. lack of familiarity with foreign markets
ii, Political risk
iii. Lack of market efficiency
iv. Regulations
v. Transaction costs
vi. Taxes
vii. Currency risks

Front 40

International Diversification

What is the traditional argument against international diversification?
(SS8)

Back 40

Traditional argument against international diversification is the "Country specific" argument.
1. When the domestic market does better than most other markets, leading some to say that there is no need for international investments in the future because the domestic market is outperforming
2. Why look elsewhere if domestic market is doing so well?
3. The thought is that the benefits of international diversification are overstated because markets tend to be more synchronised than people think especially in volatile times, so when you need a low corr, the correlations actually rise.
4. As markets become more integrated things become more synchronised and correlations have risen over time.

Front 41

International Diversification

What is the difference between global investing and international diversification
(SS8)

Back 41

i. In the 90's international diversification was done based on the allocating to a particular country based on the location of its headquarters. Back then countries were less correlated than industries so that was a better way to diversify.
ii. Now industry factors are more important


Global investing is referring to the best companies wherever they are.
International diversification is choosing to invest globally because the correlations between country markets are less than 1.0.

Front 42

International Diversification

Why even bother with emerging markets?
(SS8)

Back 42

Risks
i. volatility is large and the returns are not symmetric. The probability of a shock is higher than would be the case if the distribution of returns were normal.
ii. because non-normal distribution, the s.d isn't a sufficient measure osf market risk.
Restrictions
i. constrained by various regulations and liquidity problems
ii. Emerging markets are somewhat segmented
iii. Mispricing is evident
iv. free float
v. foreign ownership
vi. lack of liquidity means that your big trade can have a large price impact

Emerging markets often exhibit positive correlations with the value of their currencies resulting in foreign investors suffering doubly from currency risk in emerging markets.

Front 43

International Diverisfication

Correlation when markets are volatile
(SS8)

Back 43

Since the market isn't normal
1. Distributions of returns tend to have fat tails (LEPTOKURTIC). Large positive or negative returns are more likely than under normal distributions.
2. Market volatility varies over time, but volatility is 'contagious'. High volatility in the US stock market is associated with high volatility in foreign stock markets and other financial markets (like bonds and currency)
3. Correlations across markets increase dramatically in periods of high volatility, for example, during major market events such as the OCt 1987 crash.

There is correlation breakdown.
Diversification benefits don't hold when you need them to.