Asset Allocation 12-14

Question 1

government focuses on clarifying mission, creating a plan, and reviewing progress toward achieving long-and -short-term objectives.

Answer 1

the election of plan

achieve the agreed on goals and objectives

Question 2

3 levels with governance hierarchy

Answer 2

covering investment committee
investment staff
3rd pary resources

Question 3

effective governance models perform:

Answer 3

1. articulate the long and short term objectives of the investment program
2. allocate decision, rights and responsibilities among the fundamental units
3. specify process for developing and approving investment policy statement
4. specify processes for developing and approving the strategic asset allocation
5. establish a reporting framework to monitor the program’s progress toward the agreed-on goals and objectives
6. periodically undertake a governance audit

Question 4

reporting framework

Answer 4

clear & concise, accurately answering questions

address performance evaluation, compliance with inv. guidelines

progress toward achieving the stated goals and objectives

benchmark

management reporting

governance reporting -address strength and weakness in a program execution

Question 5

governance audit

Answer 5

to ensure that the established policies, procedures, and governance structure are effective

performed by 3rd independent party

Question 6

effective investment governance ensures

Answer 6

durability/survivability of the investment program

weak to avoid decision-reversal risk

Question 7

economic balance sheet

Answer 7

financial A/L
+ extended portfolio A/L

Financial asset
equity
FI

human capital
pv of trues earnings, inheritances, futures intellectual property

liability
ST borrwowing 
mortgage debt 
pv of future consumption
pv of prospective payout for foundations

Question 8

asset only
grow asset
high return/volatility

Answer 8

focus on asset side of b/s, exp(r), risk, correlations

*target an overall required return

MVO mean variance optimization is the most familiar and deeply standard asset-only approach

maximize sharpe ratio for acceptable level of volatility

Question 9

liability-relative/liability driven investing LDI

funding liability

Answer 9

objective of funding liabilities
provide money to pay liability when due

modell legal/quasi-liability
fund ability and invest excess asset and growth
penalty for not meeting liability (banks, DB, insurers)

Question 10

goal-based /GBI

support needs

Answer 10

AA for sub-portfolio
each of which is aligned to specified goals
aspirational objective

model goals with specified required probability of success - individual investors

drawback: sub-portfolio add complexity
goals maybe ambiguous/may change overtime

mental accounting
bottom-up strategic AA

Question 11

strategic asset allocation - Quant approach Utility theory

effect achieving IPS

Answer 11

optimal asset allocation

expected to provide the highest utility to the investor at the investors investment time horizon

Question 12

power utility function

Answer 12

underlies mean-variance optimization

risk aversion does not depend on level of wealth

Question 13

optimal asset allocation w* =

Answer 13

(U-rf)/(variance)*1/degree of risk aversion

Question 14

Sharpe ratio

Answer 14

higher the greater its contribution to the sharpe ratio of the overall portfolio holding.

however this condition is not usually true. Diversification potential in a portfolio may differ. Portlio risk may decrease through favorable correlation characteristics of the strategies.

Question 15

global market value weighted portfolio

on the line tangent to efficient frontier

Answer 15

1. sum all investable asset hold by investors, reflects the balancing of supply and demand across world markets
2. in financial theory, it minimizes diversification risk, which in principle is uncompensated
3. makes the most efficient use of the risk budget
4. serve as a starting point and ensure investor articulates a clear justification for moving away from global capitalization market weights

2 phases:

1. allocate asset in proportion to global portfolio of stocks, bond, real asset
2. disaggregate each of these broad asset classes in region, country, security weights using capitalization weights

Question 16

implementation hurdle

Answer 16

1. estimating the size of each asset class on a global basis is an imprecise exercise given the uneven availability of info on non-publicly traded assets
2. the practicality of investing proportionately in residential real asset, much of which is held in individual homeowners’ hands has been questioned
3. private commercial real estate and global private equity assets are not easily carved into pieces of a size that is accessible to most investors

Question 17

liability relative

Answer 17

portfolio value match the liability with a buffer

FI primarily because int rates are a major financial driver of both liability and bond value.
Bond can be important in hedging liabilities but equities can be relevant for liability hedging too.

Question 18

underfunded pension due to liability increase

Answer 18

• optimal AA in general is sensitive to changes in the fund status of the plan
• increase fund statues by decrease surplus risk overtime
• as FS change, proportion of liability hedging asset and return seeking asset and duration of liability hedged change

sensitive to int. rate, duration, inflation, credit risk

Question 19

tactical asset allocation TAA
active
ST

approaches:
1. discretional TAA
discretional relies in a qualitative interpretation of political, economic and financial market condition
2. Systematic TAA
systematic relies on quantitative signals to capture documented return anomalies that maybe inconsistent with market efficiency (value, momentum)

Answer 19

involves deliberate ST deviations from the strategic asset allocations by taking ST economic/financial market conditions that appear more favorable to certain asset classes

-investment return in short term is predictable

• ST tilt away from the strategic asset mix
• responsive to price momentum, perceived asset class valuation, stage of business cycle

Drawback:

• may incur additional cost higher trading cost and taxes
• TAA increases the concentration of risk relative to the policy portfolio

generating alpha through TAA decisions is dependent on successful market or factor timing rather than security selection

Evaluation (3 ways) between TAA and SAA

1. sharpe ratio
2. information ratio
3. scatter plots

Question 20

Dynamic asset allocation DAA

multi-period

Answer 20

deviation that are motivated by long-term valuation signals or even views

Barriers: monitory and trading cost (tax CGT)
should evaluate cost-benefit lens

Question 21

GDP-weighted global bond index involves both active/passive choices

Answer 21

passive presented by the overall selection of the universe of global bonds

active choice is represented by the weighting scheme, which is to use the GDP rather than capital market weights. Tilting away from FI to real economy

Question 22

Risk budgeting

Answer 22

variance, std of return, concern for tail risk, be quantified by VAR or drawdown, absolute/relative term

Active risk budgeting addresses the question of how much benchmark related risk an investor is willing to take in seeking to outperform a benchmark.

Question 23

rebalancing

Answer 23

discipline of adjusting portfolio weights to more closely align with the strategic asset allocation

never rebalance implies rising risk/return
countercyclical
contrarian 逆势的 investment approach
align strategic asset allocation

Question 24

percent-range rebalancing setting rebalancing thresholds or trigger points

Answer 24

target weight 50%
trigger point 45, 55%
range 10%

Question 25

strategic consideration for rebalancing using derivatives as a rebalancing tool to lower costs

Answer 25

``` widen: 正比： transaction cost correlation momentum facto tax consequences liquidity risk tolratce ``` ``` Narrow corridor: high volatility mean reversion less correlation risk averse investor ``` - higher transaction costs imply wider rebalancing ranges - more risk-averse investors will have tighter rebalancing ranges - less correlated assets also have tighter rebalancing ranges - beliefs in momentum factor widen rebalancing ranges - mean reversion encourages tighter ranges - tax discourage rebalancing and encourage asymmetric and wider rebalancing ranges

Question 26

mean-variance optimization MVO markowitz most concentrated Um=E(Rm) - 0.005(risk aversion coefficient)* Variance m coefficient = 4 moderate risk averse investor

Answer 26

maximize the expected return for an expected level of risk provide a framework to determine how much to allocate to each asset class to create optimal asset mix inputs: return, risk (std), pair-wise correlation A single portfolio with specific asset class weights at each level of return describes traditional mean variance optimization.

Question 27

reverse optimization solve output high sensitivity of input of MVO input determined by market cap weights, cov, and risk aversion coefficient. more diversified

Answer 27

result in a much more diversified allocation since it uses global market portfolio as baseline. COV - Reverse MVO - E(r) start with optimal portfolio o weight from the global market and drive E(r) run a traditional MVO based on E(r)

Question 28

Criticism of MVO inputs are historical data

Answer 28

1. output sensitivity to input (garbage-in-garbage-out) 2. concentrated allocation 3. focus of skewness and kurtosis is ignored indirectly incorporate skewness kurtosis or both into the utility function and use an asymmetric definition or risk such as conditional value at risk instead of variance 4. highly granular and narrowly defined asset classes solve: redefine the asset class more broadly and follow rules for well specified asset classes. 5. MVO is a single-period framework that does not take account of costs and taxes 6. MVO does not model liability and goals (single period approach)

Question 29

Resampled MVO Solves input sensitivity and high concentration Monte carlo similation

Answer 29

Monte carlo similation used to generate thousands of random variations of the inputs around the initial estimates, resulting thousands of simulated efficient frontiers. Mont carlo simulation solves single period framework with all possible outcomes. The resampled efficient frontier is an average of all the simulated frontiers used to create an efficient frontier at each return level and run thousands of times resulting in an efficient frontier that is the result of an averaging process. The efficient frontier becomes a blur rather than a single sharp curve. At each level of return, the most efficient of the simulated efficient portfolios is at the center of the distribution.

Question 30

risk aversion coefficient = 0 | risk neutral investor

Answer 30

optimal AA is 100% invested in EM. | Exp Utility = Exp(r)

Question 31

To achieve better-diversified efficient frontier:

Answer 31

``` reverse optimization black-litterman model concentrated asset class weight ```

Question 32

``` Solve input sensitivity: Address MVO's sensitivity to small differences in expected return estimates by archiving expected returns to those implied by the asset class weights of a proxy for the global market portfolios ```

Answer 32

reverse optimization | black-litterman model

Question 33

highest prob of exceeding 4% return

Answer 33

calculate sharpe ratio = E(r)-target / std E(r) = E(r) - 0.005*risk aversion coefficient * variance the higher, the higher problem exceeding the threshold

Question 34

Non-nominal optimization solves skewness and kurtosis, mean and variance only of MVO

Answer 34

Traditional MVO ignores non-normal distribution use 1. mean-semi variance optimization 2. mean-conditional var optimization 3. mean-variance-skewness optimization 4. mean-variance-skewness-kurtosis

Question 35

Monte carlo simulation solves single period framework with all possible outcomes. Advantages relative to MVO:

Answer 35

1. It has a multi-period framework 2. Incorporate cost of rebalancing 3. solves path-dependent issue by adjusts for change in cash flows 4. incorporates statistics outside the normal distribution, skewness and excess kurtosis

Question 36

Intepret and critique an AA in relation to an investor's economic B/S

Answer 36

investor with stable jobs with consistent capital model CF with human capital as an inflation-linked bond. investor with less certain and more volatile future wage: model human capital as a mix of inflation-linked bond, equity and corp. bonds including human capital & residential RE along with traditional investment vehicles increase investors capacity to bear risk.

Question 37

Liquidity in Asset Allocation ``` Less liquid asset classes such as direct real estate, infrastructure, and private equity - cannot be readily diversified to eliminate idiosyncratic risk, so representing overall asset class performance is problematic. - far fewer indexes that attempt to represent aggregate performance for these less liquid asset classes than indexes of traditional highly liquid asset classes. - Finally, the risk and return characteristics associated with actual investment vehicles are typically significantly different from the characteristics of the asset classes themselves. ```

Answer 37

1. it's more challenging to make capital market assumption due to the lack of accurate index for less liquid assets 2. even if there are accurate index, there are no low-cost passive investment vehicles to track them. practical options: 1. exclude less liquid asset classes from the MVO and consider RE funds as potential when fulfilling the target strategic AA. 2. include them in MVO and model the inputs to represent the specific risk characteristics 3. include then in MVO and model the inputs to represent the highly diversified characteristics associated with the true asset classes.

Question 38

3 aspects of risk budgets:

Answer 38

1. identifies the total amount of risk and allocates the risk to a portfolio's constituent parts 2. an option risk budget allocates risk efficiently 3. the process of finding the optimal risk budget is risk budgeting

Question 39

absolute/relative risk budget

Answer 39

The goal of risk budgeting is to maximize return per unit of risk. A risk budget identifies the total amount of risk and attributes risk to its constituent parts. An optimum risk budget allocates risk efficiently.

Question 40

absolute contribution to total risk (ACTR)

Answer 40

measure how much it contributes to portfolio return volatility for an asset class i ACTRi = wi * MCTR = wi * beta * std

Question 41

optimal asset allocation | excess return /MCTR = Sharpe ratio = (E(r)-rf)/MCTRi

Answer 41

is optimal AA from a risk budgeting perspective when the ratio of excess return to MCTR is the same for all assets and is equal to sharpe ratio of the portfolio.

Question 42

Fama French factor based AA solves non diversified risk of MVO

Answer 42

factors are typically observed based on market premiums and anomalies the factor represents what is referred to as a zero(dollar) investment or self-financing investment. factors generally have low correlations with the market and with one another typically similar to the fundamental/structural factors used in multi-factor models

Question 43

developing liability-relative AA

Answer 43

plan surplus = MV(A) - PV(L) | funding ratio = MV(A)/PV(L) =1 fully funded and surplus =0

Question 44

3 approaches to liability relative asset allocation | 1. surplus optimization

Answer 44

an extension of MVO that manages the portfolio surplus against the surplus volatility. Um = E(Rs,m) - 0.005 * risk aversion coefficient * Variance (Rs,M) Rsm =Surplus return = change in asset - change in liability / initial asset value minimize risk of underlying by insurance companies and overfunded pension most appropriate for conservative investors increasing allocation to the hedging portfolio as the funding ratio and the surplus increase. - links asset and pv of liability through a correlation coefficient. - 1 step - simplicity - linear correlation - all level of risk - any funding ratio - single period

Question 45

allocation to corp bond declines with increase in plan surplus return can be explained by

Answer 45

positive correlation of bond prices with the pv of liability. the hedging asset is employed to a greater degree at the low end of the surplus efficient frontier.

Question 46

3 approaches to liability relative asset allocation

Answer 46

1. Surplus optimization 2. two portfolio approach 3. integrated asset-liability approach (ALM)

Question 47

forming hedging portfolio

Answer 47

asset and liability must be drive by the same factor pv of future CF =mv of asset date of valuation of asset = date of that for liabilities

Question 48

discount rate assumption higher discount lead to higher funding ratio require lower contribution from sponsors

Answer 48

``` limitation: 1. funding ratio <1 mv(c)/pv(l)<1 basis form is not applied 2. loses due to the nature disasters cannot be hedged buy insurance ```

Question 49

3 approaches to liability relative asset allocation 3. integrated asset-liability approach (ALM) DFA dynamic financial analysis

Answer 49

jointly optimizes assets and liabilities, typically against future changes in multiple factors. potential to improve the institutions overall return - increase complexity - linear-non-linear - all level of risk - any funding ratio - multi-period

Question 50

goal based approach | E(R) with specific prob. success over the required time-horizon

Answer 50

size of inv = pr(future goal) / (1+ E(r)^n

Question 51

critique heuristic and other approach to AA | '120 - YOUR AGE'

Answer 51

% allocation to equity = 120 - age

Question 52

critique heuristic and other approach to AA | 60/40 stock/bond heuristic

Answer 52

60% equities vs. 40% bonds

Question 53

critique heuristic and other approach to AA | yale/endowment model

Answer 53

allocate larger amounts to alternative investment asset class

Question 54

critique heuristic and other approach to AA risk parity 1/n wi * cov(ri, rp) = 1/n * variance p

Answer 54

each asset class contribute the same amount to the total portfolio risk weigit = 1/n overweight less risky asset underweight more risky asset

Question 55

asset size constraints - small assets

Answer 55

disadvantage subject to small asset: - minimum requirement for some investment is not met - lower governance capacity-sophistication and manpower resources - higher internal management fees - too small to diversify across asset classes

Question 56

tax consideration interest income taxed at a higher rate than dividends/capi gains taxable assets have existing unrealized capital gains/losses which come with embedded tax liabilities.

Answer 56

r at = r pt(1-t) rat = pa rat (1-td) + pa rpt (1-tcg) std at= std pt(1-t)

Question 57

3 potential ways current market value may be adj. to reflect the a/l:

Answer 57

1. subtract the value of the embedded CGT from the current market value of the asset as if it were to be sold today 2. assume the asset is to be sold in the future and discount the tax liability to its pv using the asset after-tax return as a discount rate 3. assume asset is to be sold in the future and discount the tax liability to its pv using the after-rate rf rate.

Question 58

taxes and portfolio rebalancing Rat = Rpt/(1-t)

Answer 58

occur less frequently in the taxable portfolio due to reduction in volatility

Question 59

reduce impact of taxation: | tax loss harvesting

Answer 59

trading to realized a capital loss to offset current/future realized capital gain, thereby reducing the taxes owned by the investor

Question 60

reduce impact of taxation: | Strategic asset allocation

Answer 60

place less tax-efficient assets in accounts with more favorable tax treatment, such as retirement savings account.

Question 61

tax deferred account TDA asset appreciate tax free but are taxes upon distribution

Answer 61

AF TDA = Vat = Vpt(1-t)

Question 62

TEA | tax exempt assets

Answer 62

not subject to taxes

Question 63

changes in investment objective/constraints from:

Answer 63

``` asset size business condition investor's personal circumstances interest rate cash flow regulation time horizon liquidity needs economic environment and capital market expectation change in committee members/trustees ```

Question 64

Strategic asset allocation SAA

Answer 64

LT investment policy targets fr asset class weight

Question 65

The Norway model

Answer 65

passively invests in publicly traded securities subject to environmental, social, and governance concerns.

Question 66

5 criteria in effectively specify asset classes

Answer 66

1. asset within an asset class should be relatively homogenous 2. asset classes should be mutually exclusive 3. asset class should be diversifying 4. asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor's portfolio.

Question 67

impact of short sale on efficient frontier and asset allocation

Answer 67

- short sale constraint allows only positive asset weights, this may shift the efficient frontier downward and to the right, shifting the theoretical maximum possible return for a given level of risk downward - in practice the constraint is not an issue because few investors would allow a "permanent" strategic allocation to short position.

Question 68

Grinold-Kroner model for Equity market return

Answer 68

Expected repricing return = change in P/E ratio = 0.5% Expected income return =  dividend yield − increase in shares outstanding = 3.5% − ( −1.0%) = 4.5% Expected nominal earnings growth =  real earnings growth + inflation = 2.1% + 1.9% = 4.0%

Question 69

r=(1+s)(1+i)(1+c)

Answer 69

s spending i inflation c cost of earning

Question 70

Heuristics approach

Answer 70

refers to rules that provide a reasonable but not necessarily optimal solution, Some investors may skip the various optimization techniques and simply adopt an asset allocation mix (such as the “120 minus your age” rule or a 60/40 stock/bond mix).

Question 71

Shortfall risk

Answer 71

is a liability-relative approach focused on the risk of having insufficient assets to pay obligations when due.

Question 72

corridor width | - frequency of rebalancing from strategic asset allocation

Answer 72

narrow when rebalance often increase in volatility higher volatility makes large divergences from the strategic asset allocation more likely wider when rebalance rarely increase in transaction cost higher risk tolerance higher correlation -when asset classes move in sync, further divergence from target weights is less likely low volatility

Question 73

the two portfolio model a hedging portfolio + return seeking portfolio (mvo)

Answer 73

it allows the fund to create an asset portfolio that hedges its liabilities, while separately creating a portfolio that manages the remaining assets using mean-variance optimization (MVO) under a return-seeking approach. - 2 steps - linear/nonlinear - conservative level risk - positive funding ratio - single period

Question 74

Improvement to monte carlo simulations

Answer 74

1. refine historical base asset class expectations for expected future economic conditions 2. model the assets owned rather than generic asset classes.

Question 75

Advantage of resample efficient frontier

Answer 75

1. likely to be more stable, leading to less frequent turnover and lower transaction cost. 2. allocation likely includes more asset classes from increased diversification, consistent with her reduced risk tolerance

Question 76

advantage of black-litterman

Answer 76

adds in investors view of expected return with constrain as strategic allocation to short is highly unusual.

Question 77

Corner portfolio

Answer 77

MVO is required to find the corner portfolio it's must be on the efficient portfolio shortcut to interpolate points along the efficient frontier