AA with constraints

Question 1

What are some of the considerations with AA that occurs if the asset owner is too large?

Answer 1

• They are more likely to have the required governance capacity for more complex asset classes or strategies and identifying and monitoring submanagers
• May exhaust oppurtunities in some classes - for instance in small caps they may not have enough active investment managers in that space to accomodate them
• For the investment Manager: Big AUM means big trades, so there is more price impact. More capital inflows tempt managers to pursue ideas outside core competencies. Organisation heirarchy could slow down decision making or reduce incentives.
• Big pension plans get gains from cost savings on internal management (lower per participant costs), better negotiation on fees, and can support allocations to PE and RE that benefit from scale and out of small caps where diseconomies to scale occur.
• The desired allocation may not have a material benefit ie not enough hedge fund managers or one’s active bets undo the bets of another.
• Complex strategies may be beyond the reach of asset owners that have chosen not to develop investment expertise internally or where the oversight committee lacks individuals with sufficient investment understanding. In some asset classes and strategies, commingled investment vehicles can be used to achieve the needed diversification, provided the governing documents do not prohibit their use.

Question 2

What to consider when dealing with the constraint of liquidty?

Answer 2

• The charecteristics of the asset should match the needs of the asset owner
• This is often dictated by the institution - banks will need high liquidity for high tunorver in operations. A university endowment might need more liquidity if hard times fall and they need to support the uni. Life insurers can absorb more liquidity risk than casualty.

Question 3

What happens as time horizon shifts?

Answer 3

• As an investor’s time horizon shifts, both human capital and financial market considerations, along with changes in the investor’s priorities, will most likely lead to different asset allocation decisions.
• Over time, goals are achieved and the portfolio changes. With a goals portfolio the AA changes as different goals are the PV of remaining goals.
• People change goals ie that guy got married, now he has high priority short term goals requiring more conservative assets, but also another horizon for the children got longer so he may take more risk too.
• It is generally believed that longer-horizon goals can tolerate the higher volatility associated with higher risk/higher return assets as below average and above average returns even out over time. This is the notion of time diversification.

Question 4

Explain the EF with PV of contributions and Contribution risk

Answer 4

• So the higher you go on the Y the lower the PV of expected contributions. The X axis is the contribution risk - the amount we are 95% sure will not be exceeded.
• Going from a 70/30 to a 60/40 portfolio means less risk so we move left on the axis. Less probability of less-than-expected returns leading to unexpectedly large contributions. It also means a higher expected PV of contributons since lower equity amount rate of return. Remember going south on chart increases size of PV contribution.

Question 5

An insurance company has traditionally invested its pension plan using the asset allocation strategy adopted for its insurance assets: The pension assets are 95% invested in high-quality intermediate duration bonds and 5% in global equities. The duration of pension liabilities is approximately 25 years. Until now, the company has always made contributions sufficient to maintain a fully funded status. Although the company has a strong capability to fund the plan adequately and a relatively high tolerance for variability in asset returns, as part of a refinement in corporate strategy, management is now seeking to reduce long-term expected future cash contributions. Management is willing to accept more risk in the asset return, but they would like to limit contribution risk and the risk to the plan’s funded status. The Investment Committee is considering three asset allocation proposals for the pension plan:

A Maintain the current asset allocation with the same bond portfolio duration.

B Increase the equity allocation and lengthen the bond portfolio duration to increase the hedge of the duration risk in the liabilities.

C Maintain the current asset allocation of 95% bonds and 5% global equities, but increase the duration of bond investments.

Answer 5

Given the intermediate duration bond allocation, Proposal A fails to consider the mismatch between pension assets and liabilities and risks a reduction in the funded status and increased contributions if bond yields decline. (If yields decline across the curve, the shorter duration bond portfolio will fail to hedge the increase in liabilities.) To meet the objective of lower future contributions, the asset allocation must include a higher allocation to equities. Proposal B has this higher allocation, and the extension of duration in the bond portfolio in Proposal B reduces balance sheet and surplus risk relative to the pension liabilities. The net effect could be a reduction in short-term contribution risk; moreover, if the greater expected return on equities is realized, it should result in reduced contributions to the plan over the long term. Proposal C improves the hedging of the liabilities, and it may result in a modest improvement in the expected return on assets if the yield curve is upward-sloping. However, the expected return on Proposal C is likely lower than the expected return of Proposal B and is therefore unlikely to achieve the same magnitude of reduction in future cash contributions. Proposal C would be appropriate if the goal was focused on reducing surplus risk rather than reducing long-term contributions.

Question 6

The effect of taxes on returns:

Answer 6

• Correlation not affected
• Mean is reduced
• SD is effected - o x (1-t). There is lower highers and higher lows due to tax and the benefit of capital loss whether relaised or not.
• Look at the goals ie is it a ten year horizon, or is it for a tax free charity (ignore then)
• We can expect in a stocks, HY bonds, IG bonds portfolio that when accounting for tax the EF will change and penalise the higher taxed asset if it is no longer competitive with respect to mean, SD, corr.
• We now have 6 asset classes, the tax burden is inseparable from the economic value. So we use different inputs for each one.

Question 7

consider a portfolio with a 50% allocation to equity, where equity returns are subject to a 25% tax rate. A tax-exempt investor may establish a target allocation to equities of 50%, with an acceptable range of 40% to 60%. What about a taxable investor?

Answer 7

• after-tax volatility is less than pre-tax volatility and asset class correlations remain the same, it takes larger asset class movements to materially alter the risk profile of the taxable portfolio.
• A taxable investor with the same target equity allocation can achieve a similar risk constraint with a range of 37% to 63% (50% plus or minus 13%). The equivalent rebalancing range for the taxable investor is derived by adjusting the permitted 10% deviation (up or down) by the tax rate
• 0.10/(1-0.25) = 13.3%
• Broader rebalancing ranges for the taxable investor reduce the frequency of trading and, consequently, the amount of taxable gains.

Question 8

What taxable assets should go into which taxable or tax free portfolios?

Answer 8

• generally, interest income is taxed hardest so it is least efficient (unless its a state bond sometimes). Preferred stocks sometimes better than bonds for income, as taxed at (presumably) lower div rate. Divs and capital gains are more favoured. Long term gains are best and also capital losses may be applied.
• Taxable portfolio shouldnt have the div income share class or the high yield bonds.
• Assets with capital gains and deferred gains and eligible for lwer rates should go in taxable.
• Put bonds and high trade stuff in tax free

Question 9

When to revise the SAA?

Answer 9

• Possibly once every 5 years
• Changes in goals, constraints (liquidity, size, horizon, regulations) or beliefs.

Question 10

O-Chem Corp has a defined benefit pension plan with US$1.0 billion in assets. The plan is closed, the liabilities are frozen, and the plan is currently 65% funded. The company intends to increase cash contributions to improve the funded status of the plan and then purchase annuities to fully address all of the plan’s pension obligations. As part of an asset allocation analysis conducted every five years, the company has recently decided to allocate 80% of assets to liability-matching bonds and the remaining 20% to a mix of global equities and real estate. An existing private equity portfolio is in the midst of being liquidated. This allocation reflects a desired reduction in the level of investment risk.

O-Chem has just announced an ambitious US$15 billion capital investment program to build new plants for refining and production. The CFO informed the Pension Committee that the company will be contributing to the plan only the minimum funding required by regulations for the foreseeable future. It is estimated that achieving fully funded status for the pension plan under minimum funding requirements and using the current asset allocation approach will take at least 10 years.

What are the implications of this change in funding policy for the pension plan’s asset allocation strategy?

Answer 10

The Investment Committee should conduct a new asset allocation study to address the changes in cash flow forecasts. The lower contributions imply that the pension plan will need to rely more heavily on investment returns to reach its funding objectives. A higher allocation to return-seeking assets, such as public and private equities, is warranted. The company should suspend the current private equity liquidation plan until the new asset allocation study has been completed. A liability-matching bond portfolio is still appropriate, although less than the current 80% of assets should be allocated to this portfolio.

Question 11

What is TAA?

Answer 11

• In seeking to capture a short-term return opportunity, TAA decisions move the investor’s risk away from the targeted risk profile. TAA is predicated on a belief that investment returns, in the short run, are predictable.
• Using either short-term views or signals, the investor actively re-weights broad asset classes, sectors, or risk factor premiums. TAA is not concerned with individual security selection.
• Although tactical asset allocation shifts must still conform to the risk constraints outlined in the investment policy statement, they do not expressly consider liabilities (or goals in goals-based investing).
• The SAA policy portfolio is the benchmark against which TAA decisions are measured. Tactical views are developed and bets are sized relative to the asset class targets of the SAA policy portfolio. The sizes of these bets are typically subject to certain risk constraints. The most common risk constraint is a pre-established allowable range around each asset class’s policy target. Other risk constraints may include either a predicted tracking error budget versus the SAA or a range of targeted risk (e.g., an allowable range of predicted volatility).

Question 12

How to evaluate the success of TAA?

Answer 12

• a comparison of the Sharpe ratio realized under the TAA relative to the Sharpe ratio that would have been realized under the SAA;
• evaluating the information ratio or the t-statistic of the average excess return of the TAA portfolio relative to the SAA portfolio;
• plotting the realized return and risk of the TAA portfolio versus the realized return and risk of portfolios along the SAA’s efficient frontier. This approach is particularly useful in assessing the risk-adjusted TAA return. The TAA portfolio may have produced a higher return or a higher Sharpe ratio than the SAA portfolio, but it could be less optimal than other portfolios along the investor’s efficient frontier of portfolio choices.

Question 13

The two types of TAA:

Answer 13

• Discretionary: analysis of economic and fundamental data, as well as market sentiment indicators, to determine which asset classes to over- or underweight. Look at VIX, short interest, consumer sentiment etc assumed to drive market returns in short term. Despite the plethora of data inputs, the interpretation of this information is qualitative at its core.
• Systematic: Using signals, systematic TAA attempts to capture asset class level return anomalies that have been shown to have some predictability and persistence. Value and momentum, for example, are factors that have been determined to offer some level of predictability, both among securities within asset classes (for security selection) and at the asset class level (for asset class timing).

Question 14

How to overcome these:

Loss aversion:

Illusion of Control:

Mental Accounting:

Representativeness Bias:

Answer 14

• Loss-aversion bias is an emotional bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains.

In goals-based investing, loss-aversion bias can be mitigated by framing risk in terms of shortfall probability or by funding high-priority goals with low-risk assets.

• Illusion of Control: is a cognitive bias—the tendency to overestimate one’s ability to control events. It can be exacerbated by overconfidence, an emotional bias. If investors believe they have more or better information than what is reflected in the market, they have (excessive) confidence in their ability to generate better outcomes. They may perceive information in what are random price movements, which may lead to more frequent trading, greater concentration of portfolio positions, or a greater willingness to employ tactical shifts in their asset allocation

The illusion of control can be mitigated by using the global market portfolio as the starting point in developing the asset allocation. Deviations from this baseline portfolio must be thoughtfully considered and rigorously vetted, ensuring the asset allocation process remains objective.

• Mental accounting is an information-processing bias in which people treat one sum of money differently from another sum based solely on the mental account the money is assigned to.

Goals-based investing incorporates mental accounting directly into the asset allocation solution.
Concentrated stock positions also give rise to another common mental accounting issue that affects asset allocation. For example, the primary source of an entrepreneur’s wealth may be a concentrated equity position in the publicly traded company he founded. The concentrated stock/mental accounting bias can be accommodated in goals-based asset allocation by assigning the concentrated stock position to an aspirational goal—one that the client would like to achieve but to which he or she is willing to assign a lower probability of success.

• Representativeness, or recency, bias is the tendency to overweight the importance of the most recent observations and information relative to a longer-dated or more comprehensive set of long-term observations and information. Tactical shifts in asset allocation, those undertaken in response to recent returns or news—perhaps shifting the asset allocation toward the highest or lowest allowable ends of the policy ranges—are particularly susceptible to recency bias.

The strongest defenses against recency bias are an objective asset allocation process and a strong governance framework. It is important that the investor objectively evaluate the motivation underlying the response to recent market events. A formal asset allocation policy with pre-specified allowable ranges will constrain recency bias. A strong governance framework with the appropriate level of expertise and well-documented investment beliefs increases the likelihood that shifts in asset allocation are made objectively and in accordance with those beliefs.

Question 15

Framing Bias:

Availability Bias:

Answer 15

• Framing bias is an information-processing bias in which a person may answer a question differently based solely on the way in which it is asked. One example of framing bias is common in committee-oriented decision-making processes. In instances where one individual frequently speaks first and speaks with great authority, the views of other committee members may be suppressed or biased toward this first position put on the table. he investor’s choice of an asset allocation may be influenced merely by the manner in which the risk-to-return trade-off is presented. Risk can mean different things to different investors: volatility, tail risk, the permanent loss of capital, or a failure to meet financial goals.

The framing effect can be mitigated by presenting the possible asset allocation choices with multiple perspectives on the risk/reward trade-off. The most commonly used risk measure—standard deviation—can be supplemented with additional measures, such as shortfall probability and tail-risk measures. Historical stress tests and Monte Carlo simulations can also be used to capture and communicate risk in a tangible way. These multiple perspectives of the risk and reward trade-offs among a set of asset allocation choices compel the investor to consider more carefully what outcomes are acceptable or unacceptable.

• Availability bias is an information-processing bias in which people take a mental shortcut when estimating the probability of an outcome based on how easily the outcome comes to mind. Easily recalled outcomes are often perceived as being more likely than those that are harder to recall or understand. For example, more recent events or events in which the investor has personally been affected are likely to be assigned a higher probability of occurring again, regardless of the objective odds of the event actually occurring. Availability bias in this context is termed the recency effect and is a subset of recency, or representativeness, bias.

Employing a formal asset allocation process using the global market portfolio as the starting point for asset allocation modeling is a key component of ensuring the asset allocation decision is as objective as possible.