Asset Allocation Flashcards
Describe elements of effective investment governance and investment governance considerations in asset allocation.
Investment governance models should:
* Establish long-term and short-term investment objectives.
* Allocate the rights and responsibilities of all the involved parties.
* Specify processes for creating an investment policy statement (IPS).
* Specify processes for creating a strategic asset allocation.
* Apply a reporting framework to monitor the investment program’s stated goals and objectives.
* Include periodic review of the governance policies by an independent third party.
Formulate an economic balance sheet for a client and interpret its implications for asset allocation.
An economic balance sheet contains an organization’s financial assets and liabilities, as well as any nonfinancial assets and liabilities that are applicable to the asset allocation decision. These nonfinancial assets and liabilities are referred to as extended portfolio assets and liabilities because they are not included on traditional balance sheets. A practical application of an investment that includes human capital (an extended portfolio asset) is a life-cycle balanced fund. These funds consider the changing levels of human capital and financial capital for an individual investor over time.
Compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation approaches.
Asset-only approaches: make asset allocation decisions based on the investor’s assets.
Liability-relative approaches: involve asset allocation decisions based on funding liabilities.
Goals-based approaches: are geared toward asset allocations for subportfolios, which help an individual achieve lifestyle and aspirational financial objectives.
Contrast concepts of risk relevant to asset-only, liability-relative, and goals-based asset allocation approaches.
asset-only approaches: focus on asset class risk as well as constructing effective asset class combinations. The relevant risk measure is the standard deviation of portfolio returns.
liability-relative approaches: focus on not having enough assets to pay liabilities when they come due. The relevant risk measure is the standard deviation of the surplus.
goals-based approaches: focus on the risk of not being able to achieve the stated financial goals.
Explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification.
Asset classes have been appropriately specified if:
* Assets in an asset class have similar attributes from both a descriptive and statistical perspective.
* Assets cannot be classified into more than one asset class.
* Asset classes are not highly correlated.
* Asset classes cover all possible investable assets.
* Asset classes contain a sufficiently large percentage of liquid assets.
Explain the use of risk factors in asset allocation and their relation to traditional asset class–based approaches.
Investors select asset classes based on their desired exposure to common risk factors. Examples of risk factors include:
* volatility
* liquidity
* inflation
* interest rates
* duration
* foreign exchange
* default risk
Risk factor exposures may overlap across multiple asset classes. Examining these overlapping risk factors can help investors identify the correlations among asset classes.
What is Strategic asset allocation
Strategic asset allocation is long term in nature; hence, the weights are called targets and the portfolio represented by the strategic asset allocation is called the policy portfolio.
Describe the use of the global market portfolio as a baseline portfolio in asset allocation.
Investors may consider the global market portfolio as a baseline asset allocation. It will minimize (eliminate) diversifiable risk. Because it’s challenging to invest in some asset classes within the market portfolio, investors often use a proxy, such as a portfolio of exchange-traded funds (ETFs).
Discuss strategic implementation choices in asset allocation, including passive/active choices and vehicles for implementing passive and active mandates.
The SAA can be implemented with passive or active management for both asset class weights and allocations within asset classes.
* TAA introduces active decisions to deviate from the SAA in an effort to add value, but it is likely to increase error.
* Active management security selection is based on investor insights or expectations.
Risk budgeting specifies which risks and how much of each risk can be taken.
Active risk budgeting specifies risk as allowable deviations from the portfolio’s benchmark.
Discuss strategic considerations in rebalancing asset allocations.
Calendar rebalancing: is done on a periodic basis, and
Percentage-range rebalancing: is done when a corridor is breached.
Wider optimal corridors are associated with:
* Higher transaction costs (including costs due to tax and illiquidity).
* Increased investor risk tolerance.
* Higher correlations among asset classes.
* Belief in momentum and that trends persist.
* Less volatile asset classes.
Derivatives may allow synthetic rebalancing at a lower cost.
Capital gains taxation suggests setting asymmetric rebalancing corridors (28%-35%).
What are the 9-Steps for selecting and justifying a strategic asset allocation.
- Determine investor objectives.
- Determine investor tolerance for risk.
- Determine investor time horizon(s).
- Determine investor constraints.
- Select the asset allocation approach.
- Specify the asset classes.
- Develop potential asset allocations.
- Simulate results of potential asset allocations.
- Repeat Step 7 until the optimal asset allocation is discovered.
Describe and evaluate the use of mean–variance optimization in asset allocation.
MVO: identifies the portfolio allocations that maximize return for every level of risk. If we assume the opportunity set includes all assets, the result is the efficient frontier.
MVO is criticized for:
* GIGO: highly sensitive to the quality of the inputs.
* Concentrated asset class allocations
* Skewness and kurtosis
* Ignoring liabilities
* Single-period framework
Recommend and justify an asset allocation using mean–variance optimization.
MVO provides an efficient frontier of asset allocation choices. However, the allocation selected will depend on the specific investor.
Variations on MVO may be used:
* Resampling: uses multiple sets of inputs to make the final result less dependent on initial assumptions
* Reverse optimization: solves for expected return by asset class based on the classes’ weights in the world market portfolio.
* Black-Litterman: allows the manager to view and adjust those consensus return expectations.
* Monte Carlo Simulation (MCS): complements MVO
Interpret and evaluate an asset allocation in relation to an investor’s economic balance sheet
A significant portion of the typical investor’s asset portfolio is human capital and also the residential real estate property the investor owns and lives in. We can adapt the MVO framework to incorporate these kinds of assets.
Discuss asset class liquidity considerations in asset allocation.
Less-liquid asset classes like direct real estate, infrastructure, and private equity require a liquidity return premium to compensate the investor for the additional liquidity risk.
