4. ASSET ALLOCATION STRATS

Question 1

AA performance explanation

Answer 1

Explains 40% of variation of returns among funds
90% of variability of a funds returns over time

• but AA is also decided by client risk tolerance, time horizon, indiv wealth objectives

Question 2

Objectives of LTAA

Answer 2

• customer profile reqs (financial circ, needs, priorities, capacity tto take risk)
• formulation of strat to achieve income/capital needs
  (liabilities, ethical considerations, remaining within risk tolerance, liquidity and accessibility)

widely used approach - LT SAA with TAA overlay

Question 3

Qual vs Quant approach to AA

Answer 3

Quali = required PM to use skill/judgement/knowledge of markets and econs to establish which asset classes to invest in

Quant - associated with computer algos that analyse large amounts of data to produce optimal short and long term AA decisions
- include buy and sell price targets
- macro trend signals

Question 4

SAA

Answer 4

Widely used approach is SAA with TAA overlay

SAA is
- relatively static
- usually set using proportions of externally recognised global BM
- peer group/fund compositions
- extensive risk/return numerical data

infrequently changed and reflecting a ‘neutral’ LT position
Usually managers given permitted range to operate within

diversified within and across asset classes
be suitable for client risk profile/needs/circs/time horizon/liquidity needs/liabilities/ESG preferences

Question 5

TAA

Answer 5

Often used as an overlay to SAA - TAA considered relative to the long term strategic benchmark

chasing alpha by ow/uw asset classes from their LT SAA weight
taking advantage of short term market movements, development

more frequently adjusted - monthly/quarterly

May use derivs to provide tactical overlays given the shorter time period - can deploy rapidly and cost effectively (cheaper and quicker)

Question 6

Asset liability management (ALM)

Answer 6

= practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy

ALM = common with pension funds where this is a future liabilty to be met - penalty for not funding liabilities can be severe with legal and reg consequences

Question 7

MVO formulas

Answer 7

Question 8

MVO - Mean Variance Optimization

Answer 8

in 2 asset portfolio - MVO will give you the optimal proportions of each asset to hold
M = optimal portfolio = highest excess return per unit of risk on curve (tangent on curve from RFR = capital markets line)

MVP = minimum variance portfolio = left most point on curve and least risky portfolio

Efficient frontier in bold = optimal portfolio for any given level of risk

Involving 3rd asset = rfr -can borrow @ risk free rate and invest in M OR invest in M and save at RFR

curve is a plot of all all the permutations of Wa/Wb

Question 9

Issues with MVO

Answer 9

Historical data used to estimate future returns/risk which may not be predictive

MVO models v sensitive to changes in estimates in expected returns and can generate unreasonable solutions

Question 10

How to cal weightings for MVP

Answer 10

Weighting in other asset = 1-answer

CovAB = CorrAB x SDA x SDB

Question 11

Constrained vs unconstrained MVO

Answer 11

Standard MVO
- No negative weights
-Weights must add to 100

Black theorem allows you have to have negative weightings and gearing (>100%) = unconstrained MVO

Shifts efficient frontier up and left = higher return with decreased risk through gearing and shorting (HF love this topic)
Obvs only works like this when longs/shorts work the right way or efficient frontier can move down and right

Question 12

Black Theorem and Unconstrained MVO

Answer 12

THEORY IS with the two corner portfolios you can recreate the entire efficient frontier

MVP = corner 1
100% in most risky asset = corner 2

Theory also says - there is a portfolio with zero correlation to M. Rz tangent to M - may give better combo of returns than investing in the rfr

Question 13

Risk budgeting

Answer 13

Involves setting LT plan of risks to take on portfolio - rive tolerance of investor is critical

• set tolerable risk target for portfolio over specified time horizon
• construct portfolio that matches target risk profile
• implement policy and manage so risk remains close to target

e.g. equal distribution of risk with risk parity management

Question 14

Risk premia/return driver approach

Answer 14

Approach diversifies portfolio @ level of risk and return streams

Control £ value of risk buckets instead of £ value of asset classes

HF stats aim to systematically isolate and harvest excess returns from exposure to specific risk factors e.g. rates, inflation, credit, growth, value etc

Useful given traditional asset classes have varying level of correlation - e.g. HY bonds may be correlated to equity, as with infra trusts - may be running more equity risk than intended

New approach - may need to reskill IMs
Additional complexity - does this raise costs to client?

Question 15

Market timing

Answer 15

Assumes markets are inefficient at least ST - rejecting strong form EMH - markets must over/underreact to new info and mispricing can therefore be exploited

Question 16

TAA approached to market timing

Answer 16

Adjust beta/duration of portfolio is bullish/bearish on markets

increase/decrease riskier holdings - small cap/EM equities

purchase futures/call options if bullish

sell futures/purchase put options if bearish

Question 17

Market timing based on spread measures

Answer 17

Spread measures used to eval when market timing may be appropriate tho quite 1 dimensional

Earnings yield spread: GRY - earnings yield
Divi yield spread: GRY - divi yield
Term spread: Long GRY - short GRY
Default Spread: GRY of corp - GRY of gilt

Question 18

Earnings yield spread

Answer 18

EY = total return avail from shares
EY spread = GRY - EY
We would expect EYS to be negative - because equities are higher risk so offer higher return
If EYS is 0 or pos - then bonds more attractive than equities
Way of looking @ relative value

Question 19

Divi yield spread

Answer 19

DY = income component of returns from shares
DYS = GRY - divi yield
Would expect GRY>DY - as issuers dont tend to pay out huge sums in divi

If you think this gap is likely to expand - could be that equity growth rates will increase (and divi reduce) or equity risks will fall (reducing risk premium) - both + for equities

Question 20

Term spread

Answer 20

= Long GRY - Short GRY
Looking @ yield curve - normal upward slope = longer dated GRY> shorter dated GRY
Inverted curve predicts recession (term spread is negative)

Question 21

Credit spread aka default spread

Answer 21

= GRY corp - GRY gilt
Diff between yield on corp bond and gov bond of similar mats

Large = increased risk/worry of default

Tend to be narrow in growing economy and widen in recession/times of crisis

Can also look @ spreads of HY > IG

Question 22

ACTIVE SHARE

Answer 22

=[ SUM (Abs diff between weightings in portfolio vs BM)] /2

used to calc degree of active management

Question 23

Tracking error

Answer 23

Active risk/ departure from BM
Views riskiness of a fund as being determined by deviation relative to index which may/may not be appropriate

Question 24

Efficient frontier

Answer 24

Set of investments that provide highest return for given level of risk

Rational investors = want max return for lowest risk so would want portfolio on efficient frontier

M - optimal portfolio?

MPV?