Asset Allocation (10.20.24) Flashcards
Primary determinant of long-run portfolio performance
Asset allocation
Transcription error
error in gathering and recording data
Anchoring bias
tendency to give disproportionate weight to the first information received or first number envisioned
prudence bias
tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting
give more weight in a way that creates safety
availability bias
tendency to be overly influenced by events that have left a strong impression and/or which it is easy to recall an example
Aggregate Market Value of Equity / V(e)
level of nominal GDP * share of profits in economy * P/E
GDP * S(k) * PE
3 Major Approaches to Economic Forecasting
1) Econometric models
2) Indicators
3) Checklists
Econometrics
Application of statistical methods to model relationships among economic variables
Structural models
Specify functional relationships among variables based on economic theory
Reduced-form models
Statistical credit models that solve for the probability of default over a specific time period, using observable company-specific and market-based variables
Economic indicators
economic statistics provided by government and established private organizations that contain info on an economy’s recent past activity or its current or future position in the business cycle
Diffusion index
reflects the proportion of the index’s components that are moving in a pattern consistent with the overall index
Business cycle
fluctuations in the GDP in relation to long-term trend growth, usually lasting 9-11 years
5 Phases of the Business Cycle
1) Initial Recovery
2) Early Expansion
3) Late Expansion
4) Slowdown
5) Contraction
Initial Recovery (markers)
1) Business confidence rises
2) Stimulative policies are still in place
3) Negative output gap is large
4) Inflation is decelerating
5) Upturn in spending on housing and consumer durables
6) Short-term rates and government bond yields are low
7) Stock market rises as fears of recession dissipate
8) Cyclical, risky assets, and small stocks perform well
Early expansion (markers)
1) Unemployment starts to fall
2) Output gap remains negative
3) Consumers borrow and spend
4) Businesses step up production and investment
5) Profit rises rapidly
6) Demand for housing and consumer durables is strong
7) Short rates move up, as stimulus is withdrawn
8) Longer-maturity bond yields rising slightly
9) Yield curve flattens
10) Stocks trend upward
Late expansion (markers)
1) Output gap closed
2) Economy in danger of overheating
3) Boom mentality prevails
4) Unemployment low, profits are strong, wages and inflation rise, and investment spending increases
5) Debt coverage ratios deteriorate as balance sheets expand and interest rates rise
6) Central bank aims for soft landing
7) Interest rates rise
8) Yield curve continues to flatten
9) Stocks rise, but are volatile
10) Cyclical assets underperform/inflation hedges outperform
Slowdown (markers)
1) Economy slows and peaks, in response to rising interest rates, fewer viable investment projects, and accumulated debt
2) Vulnerable to shocks
3) Business confidence wavers
4) Inflation rises as costs rise
5) Short-term rates are high
6) Yield curve inverts
7) Credit spreads weaken
8) Stock market falls, and flight to quality happens
Contraction (markers)
1) Recessions typically last 12 to 18 months
2) Firms cut production sharply
3) Central bank eases monetary policy
4) Profits drop sharply
5) Tightening credit magnifies downward pressure on the economy
6) Major bankruptcies, incidents of uncovered fraud, exposure of aggressive accounting practices, financial crises
7) Unemployment rises quickly, impairing household financial positions
8) Short-term interest rates drop
9) Yield curve substantially steepens
10) Stock market initially declines but improves at the later stages
11) Credit spreads widen
Two areas that deflation affects negatively
1) Debt-financed instruments
2) The power of central banks
Analogy that represents the asymmetry in power of monetary policy
Expansionary policy is like pushing on a string, whereas restrictive policy is like pulling on a string
Taylor rule
A rule linking a central bank’s target short-term interest rate to the rate of growth of the economy and inflation
neutral real policy rate + (expected growth - trend growth) / 2 + (expected inflation - target inflation) / 2
High Real Rate + high Expected Inflation
High Nominal Rates
Low Real Real + high Expected Inflation
Mid Nominal Rates
High Real Rates + Low Expected Inflation
Mid Nominal rates
Low Real Rates + Low Expected Inflation
Low Nominal rates
National income accounting equation
(X-M) = (S-I) + (T-G)
4 Primary mechanisms by which the current and capital accounts are kept in balance
1) Changes in income (GDP)
2) Relative prices
3) Interest rates and assets prices
4) Exchange rates
3 Approaches to Forecasting
1) formal tools
2) surveys
3) judgement
formal tools
established research methods amenable to precise definition and independent replication of results
surveys
asking a group of experts for their opinions
judgement
qualitative synthesis of information derived from various sources and filtered through the lens of experiences
3 Categories of formal forecasting tools
1) Statistical methods
2) Discounted Cash Flow Models
3) Risk premium models
3 Types of Statistical methods
1) Well-known sample stats
2) Shrinkage estimation
3) Time-series estimation
Shrinkage estimation
estimation that involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weight reflects the analyst’s relative belief in the estimates
Time-series estimation
Estimators that are based on lagged values of the variable being forecast; often consist of lagged values of other selected variables
3 Main methods for modeling risk premiums
1) Equilibrium model (CAPM)
2) Factor model
3) Building blocks
3 Ways to forecast fixed income returns
1) DCF (most precise)
2) Risk premium approach
3) Equilibrium model
Yield to maturity
single discount rate that equates the present value of a bond’s cash flows to its market price
4 Main Drivers of the term premium for nominal bonds
1) Level-dependent inflation uncertainty
2) Ability to hedge recession risk
3) Supply and demand
4) Cyclical effects
Grinold-Kroner Model
expected return on a share, represented as the sum of an expected income return, an expected nominal earnings growth return, and an expecting repricing return
dividend yield + (expected delta in shares outstanding + expected delta in total earnings) + delta in P/E
Expected return on real estate
Cap rate + NOI growth rate - % change in cap rate
3 Primary Ways in which trade in goods and services can influence exchange rates
1) Directly through flows
2) Quasi-arbitrage of prices
3) Competitiveness and sustainability
Volatility clustering
tendency for large (small) swings in prices to be followed by large (small) swings in random direction
Decision-reversal risk
the risk of reversing a chosen course of action at the point of maximum loss (exactly the wrong time)
Economic balance sheet
extended balance sheet that includes the present values of both lifetime earnings and future consumption
Extended portfolio assets and liabilities
assets and liabilities beyond those shown on a conventional balance sheet that are relevant in making asset allocation decisions; an example is human capital
Utility theory
the optimal asset allocation is the one that is expected to provide the highest utility to the investor at the investor’s investment time horizon
Dynamic asset allocation
Investment strategy premised on long-term asset allocation with short-term tactical trading to maintain investment allocation targets
Criticism of MVO
1) Outputs are highly sensitive to small changes in the inputs
2) Asset allocations tend to be highly concentrated in a subset of the available asset classes
3) Many investors are concerned about more than the mean and variance of returns, the focus of MVO
4) Although asset allocations may appear diversified across assets, the sources of risk may not be diversified
5) Most portfolios exist to pay for a liability or consumption series and MVO allocations are not directly connected to what influences the value of the liability or the consumption series
6) MVO is a single period framework that does not take account of trading/rebalancing costs and taxes
Skewness
Measures the degree to which return distributions are asymmetircal
Kurtosis
Measures the thickness of the distributions’ tails (how frequently extreme events occur)
Skewness and Kurtosis in Normal distribution
0
3 Aspects to Risk Budgeting
1) Risk budget identifies the total amount of risk and allocates the risk to a portfolio’s constituent parts
2) Optimal risk budget allocates risk efficiently
3) The process of finding the optimal risk budget is risk budgeting
Marginal contribution to risk (MCTR)
asset beta relative to portfolio * portfolio standard deviation
identifies the rate at which risk would change with a small (marginal) change in the current weights
Absolute contribution to risk (ACTR)
asset weight in portfolio * MCTR
measures how much an asset contributes to portfolio return volatility
ratio of excess return to MCTR
(expected return - risk-free rate)/standard deviation
When is asset allocation optimal from a risk-budgeting perspective
When the ratio of excess return (over the risk-free rate) to MCTR is the same for all assets and matches the Sharpe ratio of the tangency portolio
Surplus
market value (assets) - present value (liabilities)
120 Minus your age rule
percent allocated to stocks
Endowment/Yale model
An approach to asset allocation that emphasizes large allocations to non-traditional investments, including equity-oriented investments driven by investment manager skill (private equity)
Norway model
Asset allocation that is committed to passive investments in publicly traded securities, with very little to no allocation to alternative investments
Risk Parity Asset Allocation
Notion that each asset (asset class or risk factor) should contribute equally to the total risk of the portfolio for a portfolio to be well diversified
weight of asset i * covariance of asset i with the portfolio = (1/number of assets) * variance of the portfolio
needs to be solved using some form of optimization (mathematical programming)
Criticism of risk parity asset allocation
it focuses exclusively on risk and ignores returns
1/N rule
1/N wealth is allocated to each of N assets
all assets are treated as indistinguishable in terms of mean returns, volatility, and correlations
3 Benefits of rebalancing
1) Diversification return
2) Short volatility return
3) Return from supplying liquidity to the market
3 Approaches to liability-relative asset allocation
1) Surplus optimization
2) Hedging/return-seeking
3) Integrated asset-liability approach
Surplus optimization
Involves MVO applied to surplus returns
Hedging/return-seeking
Used when you have a liability to fund in the future, but you have surplus funds now to get there.
Assigns assets to one of two portfolios. Objective of hedging portfolio is to hedge the investor’s liability stream.
Any remaining funds are investing in the return-seeking portfolio
Integrated asset-liability apporach
Integrates and jointly optimizes asset and liability decisions
Two dimensions of liquidity to be considered when developed asset allocation solution
1) Liquidity needs of the asset owner
2) Liquidity characteristics of the asset classes in the opportunity set
Loss Aversion Bias
Emotional bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains
Which behavioral bias is related to marginal utility of wealth
Loss aversion
In goals-based investing, how can loss aversion bias be mitigated
1) Framing risk in terms of shortfall probability
2) Funding high-priority goals with low-risk assets
What type of bias in illusion of control
cognitive bias
Investor behaviors attributed to illusion of control
1) Alpha-seeking behaviors, such as market timing
2) Alpha-seeking behaviors based on a belief of superior resources (institutional investors)
3) Excessive trading, use of leverage, or short-selling
4) Reducing, eliminating, or even shorting asset classes that are a significant part of the global market portfolio based on non-consensus return and risk forecasts
5) Retaining a large, concentrated legacy asset that contributes to diversifiable risk
How can illusion of control be mitigated
Using global market portfolio as the starting point in developing the asset allocation
What type of bias is mental accounting
Information-processing
Representativeness bias
Tendency to overweight the important of the most recent observations and information relative to a longer-dated or more comprehensive set of long-term observations and information
What type of bias is framing bias
Information-processing bias
Shortfall probability
The probability of failing to meet a specific liability or goal
Home bias
Preference for securities listed on the exchanges of one’s home country
Effect on bond yields if a country’s exchange rate is severely undervalued and is expected to rise substantially against another country’s
Bond yields would be lower than they would otherwise be in relation to the other country
When two currencies are pegged or linked, how will the bond yields of the country with the weaker currency move
Likely to rise higher unless the market is confident that the government will maintain the peg
impact of above average inflation on bonds
erodes purchasing power of future cash flows, so bonds are worth less
why would you avoid checklist economic modeling approach
too time consuming because they require looking at the widest possible range of data and may require subjective judgement
why would you avoid econometric model approach
may be difficult to construct, estimate and interpret if they contain more than a few variables, yet more variables may be needed to make a model more realistic
simplest forecasting approach
leading indicator-based analysis
7 steps of setting Capital market expectations (CMEs)
1) Specify the set of expectations needed, including the time horizon to which they apply
2) Research the historical record
3) Specify the method(s) and or models to be used and their information requirements
4) Determine the best sources of information needs
5) Interpret the current investment environment using the selected data and methods, applying experience and judgement
6) Provide the set of expectations needed, documenting conclusions
7) Monitor actual outcomes and compare them with expectations, providing feedback to improve the expectation-setting process
Impact of appraisal data bias on asset correlations
They tend to be understated
Growth rate in aggregate market value of equity formula (factors)
Growth rate of nominal gdp + change in share of profits in gdp + change in p/e + dividend yield
Growth rate of nominal gdp formula
growth of real gdp + inflation
growth of real gdp = growth rate of labor input + growth rate of labor productivity
When basing conclusions on objective evidence and analytical procedures, which bias are you mitigating
availability
short-term interest rates when economy is in initial recovery phase
low and bottoming
monetary policy in late upswing
interest rates rise, monetary policy becomes more restrictive
yield curve shape in expansionary phase
steeper for short-term rates and flattening for longer-term rates
Long-run expected or required return for commercial real estate
Cap Rate + NOI growth rate
Steady-state NOI growth rate for commercial real estate = growth rate in GDP
Formula for beta in relation to variances
Covariance between securities / variance of market
Variance of the market formula
1) Expected return - risk-free rate = Return premium
2) return premium / sharpe ratio = standard deviation
3) Standard deviation ^ 2 = variance
Singer-Terhaar Approach
1)
Fully integrated risk premium = standard deviation * correlation between sector and the market * sharpe ratio
Fully segmented risk premium = standard deviation * sharpe ratio
2) Fully integrated and segmented risk premium, considering the degree of integration = (fully integrated risk premium * integration ratio) + (fully segmented risk premium * (1-integration ratio)
3) Expected return estimate = fully integrated and segmented risk premium, considering degree of integration + risk-free rate
Correlation between REITs and direct real estate vs equities
in the short run, more correlated with equities
in the long run, more correlated with real estate
Relationship between the true variance of real estate returns and variance of the observed data
true variance of returns is greater than the observed data
When would expected return of fixed income investment be unchanged if yield curve shifts
If the investment horizon equals the Macaulay duration of the portfolio, the capital loss created by the increase in yields and reinvestment effects (gains) will roughly offset, leaving the realized return approximately equal to the original yield to maturity
Based on the building block approach to fixed income returns, the dominant source of the yield spread for developed economies is what
term premium
Emerging market risk guidelines
Fiscal deficit/GDP > 4%
Debt/GDP > 70%
Current account deficit > 4%
foreign exchange reserves < 100% of short-term debt
Equity vs bonds premium method
method for calculating historical equity risk premium
Historical equity returns - historical 10-year government bond yield= historical equity risk premium
given risk premium and standard deviation, solve for sharpe ratio
risk premium for overall global investable market / expected standard deviation for the market portfolio
Given correlations, standard deviations, risk premiums, how to tell which industry is most attractive from a valuation perspective
You can tell which industry would have the highest expected return, but highest expected return does not provide valuation, so you cannot tell
Risks faced by investors in emerging market equities over and above those that are faced by fixed income investors
- Corporate governance risks
- Ownership claims may be expropriated by corporate insiders, dominant shareholders or the government
- Interest parties may misuse the companies’ assets
- Weak disclosure and accounting standards may result in limit transparency that favors insiders
- Weak checks and balances on governmental actions may bring uncertainty
Under Singer-Terhaar model, when a market becomes more globally integrated, what happens
required return declines, market delivers an even higher return than was previously expected or required, and allocation to markets that are moving toward integration should be increased
increased allocation will come at the expense of markets that are already highly integrated, usually from developed markets to emerging markets
Under Singer-Terhaar model, when a market becomes more segmented, what happens
Required return rises, market delivers lower return than was previously expected or required, and allocation to markets that moving toward segmentation should be decreased
According to purchasing power parity, if inflation is rising, what happens to currency
expected to depreciate
Orders of supporting flow to hold a currency, that might trigger a currency crisis
1) Private investments (most supportive)
2) Public equities
3) Public debt (least supportive)
What is the least supportive to a country’s currency
Public debt because it has to be serviced and must be either repaid or refinanced, potentially triggering a crisis
Main issues that arise when conducting historical analysis of real estate returns
1) Properties trade infrequently so analysis relies on appraisals
2) Each property is different, heterogeneous
3) Volatility is understated
4) Correlates are distorted
probability ratio / shortfall ratio
(return for portfolio - required return threshold) / standard deviation of the portfolio
Black-Littman Model
an extension of MVO that starts with the market portfolio to derive equilibrium returns using reverse optimization
it then incorporates subjective views on expected returns for certain assets or asset classes
key word: “reverse optimization”
The role of monte carlo simulation in MVO
Complements MVO by addressing the limitations of MVO as a single-period framework
Also helps when the investor’s risk tolerance is either unknown or or in need of further validation
Major drawback of using historical inputs for MVO
heavy concentration in a subset of available asset classes
Using risk parity allocation, what is the weight for an asset class in a 4-asset portfolio who’s return is the lowest and covariance is also the lowest
more than 1/n (25%) because all assets under risk parity must contribute the same risk and if covariance is the lowest, they must have a higher relative weight to achieve the same contribution to risk as the other asset classes
How does volatility affect rebalancing corridors
Higher volatility = narrower corridors
Lower volatility = wider corridors
How does correlation affect rebalancing corridors
Higher correlation = Wider corridors
Lower correlation = narrower corridors
How do transaction cots affect rebalancing corridors
Higher transaction costs = wider corridors
Lower transaction costs = narrower corridors
Do there exist low-cost passive investment vehicles to track aggregate performance of private equity
no
Where are MVO portfolios most sensitive
measurement errors in the expected return
What risk are MVO portfolios based on
market risk only
Asset allocation for MVO vs. reverse optimization
MVO - asset allocation weighs are outputs of the optimization with the expected returns, covariances, and a risk aversion coefficient used as inputs
reverse optimization - asset allocation weights are inputs and are determined by the market cap weights of the global market portfolio, so if bonds have large market cap, more weight will be given to them
Expected returns for MVO vs reverse optimization
MVO - expected returns are inputs to the optimization with the expected returns generally estimated using historical data
reverse optimization - expected returns are outputs of optimization with the market cap weights, covariances, and risk aversion coefficients used as inputs
Incremental return added through tactical asset allocation
(TAA weights - policy weights) * period returns
Volatility of assets held in taxable accounts after-tax vs. pre-tax
after-tax return volatility less than pre-tax return volatility
Corner portfolio
Specific point on the efficient frontier, where the weight of an asset in the portfolio changes from 0 to positive or positive to 0
inputs for standard MVO
expected return, expected risks, and pairwise correlations
when is the hedging/return seeking portfolio approach not appropriate
when the funding ratio is under 1 (unless there is expected a large contribution to bring it back to 1)
OR
when a hedging portfolio is not possible, like for weather related events
within a VCV, how many distinct covariance elements are there
with N assets, there are N(n-1)/2) distinct elements
100 assets, 4,950 distinct elements
Rule of thumb for constructing VCV matrix
there should be 10x the number of historical observation periods as there are assets
