Asset Allocation

Question 1

Describe elements of effective investment governance and investment governance considerations in asset allocation.

Answer 1

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.

Question 2

Formulate an economic balance sheet for a client and interpret its implications for asset allocation.

Answer 2

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.

Question 3

Compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation approaches.

Answer 3

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.

Question 4

Contrast concepts of risk relevant to asset-only, liability-relative, and goals-based asset allocation approaches.

Answer 4

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.

Question 5

Explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification.

Answer 5

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.

Question 6

Explain the use of risk factors in asset allocation and their relation to traditional asset class–based approaches.

Answer 6

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.

Question 7

What is Strategic asset allocation

Answer 7

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.

Question 8

Describe the use of the global market portfolio as a baseline portfolio in asset allocation.

Answer 8

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).

Question 9

Discuss strategic implementation choices in asset allocation, including passive/active choices and vehicles for implementing passive and active mandates.

Answer 9

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.

Question 10

Discuss strategic considerations in rebalancing asset allocations.

Answer 10

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%).

Question 11

What are the 9-Steps for selecting and justifying a strategic asset allocation.

Answer 11

1. Determine investor objectives.
2. Determine investor tolerance for risk.
3. Determine investor time horizon(s).
4. Determine investor constraints.
5. Select the asset allocation approach.
6. Specify the asset classes.
7. Develop potential asset allocations.
8. Simulate results of potential asset allocations.
9. Repeat Step 7 until the optimal asset allocation is discovered.

Question 12

Describe and evaluate the use of mean–variance optimization in asset allocation.

Answer 12

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

Question 13

Recommend and justify an asset allocation using mean–variance optimization.

Answer 13

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

Question 14

Interpret and evaluate an asset allocation in relation to an investor’s economic balance sheet

Answer 14

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.

Question 15

Discuss asset class liquidity considerations in asset allocation.

Answer 15

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.

Question 16

Explain absolute and relative risk budgets and their use in determining and implementing an asset allocation.

Answer 16

The goal of risk budgeting is to maximize return per unit of risk, where we can define risk as total portfolio risk, active risk, or residual risk.

Question 17

Describe how client needs and preferences regarding investment risks can be incorporated into asset allocation.

Answer 17

Ways to incorporate client risk preferences into asset allocation include:
* Specifying additional constraints.
* Specifying a risk aversion factor for the investor.
* Using Monte Carlo simulation

Question 18

Discuss the use of Monte Carlo simulation and scenario analysis to evaluate the robustness of an asset allocation.

Answer 18

Monte Carlo simulation can be used to:
1. address the limitations of MVO as a single-period model and the related issues of rebalancing and taxes in a multiperiod framework
2. guide individual investors to identify their risk tolerance level.

Question 19

Describe the use of investment factors in constructing and analyzing an asset allocation.

Answer 19

Investment factors can be used in asset allocation by defining the opportunity set as risk factors that affect expected return. Such factors include:
* market exposure
* size
* valuation
* momentum
* liquidity
* duration
* credit
* volatility.

Question 20

Describe and evaluate characteristics of liabilities that are relevant to asset allocation.

Answer 20

The following characteristics of liabilities are relevant to the asset allocation decision:
* Fixed versus contingent.
* Legal versus quasi-legal.
* Duration and convexity.
* Liability value versus size of the sponsoring organization.
* Factors that affect future cash.
* Timing considerations.
* Regulations affecting the determination of the liability’s value.

Question 21

Discuss approaches to liability-relative asset allocation.

Answer 21

There are 3 common approaches to liability-relative asset allocation.
1. Surplus optimization: Use MVO to determine an efficient frontier based on the surplus with its volatility as our measure of risk, stated either in money or percentage terms.
2. Two-portfolio approach: Separate the asset portfolio into two subportfolios: a hedging portfolio and a return-seeking portfolio.
3. Integrated asset-liability approach: Jointly optimize the selection of both the assets and the liabilities.

Question 22

Recommend and justify a liability-relative asset allocation.

Answer 22

There are 3 common approaches to liability-relative asset allocation.
1. Surplus optimization: Use MVO to determine an efficient frontier based on the surplus with its volatility as our measure of risk, stated either in money or percentage terms.
2. Two-portfolio approach: Separate the asset portfolio into two subportfolios: a hedging portfolio and a return-seeking portfolio.
3. Integrated asset-liability approach: Jointly optimize the selection of both the assets and the liabilities.

Question 23

Recommend and justify an asset allocation using a goals-based approach.

Answer 23

The goals-based approach is useful for individual investors, who typically have a number of (sometimes conflicting) objectives, with different time horizons and different levels of urgency.
* The investor’s portfolio is composed of subportfolios, and each investment goal is addressed individually with these subportfolios.
* Taxable and tax-exempt investments are part of the opportunity set.
* Minimum expectations are specified for each goal.

Question 24

Describe and evaluate heuristic and other approaches to asset allocation.

Answer 24

Additional ad hoc approaches to asset allocation include:
* 120 minus your age.
* 60/40 split.
* Endowment model or Yale model.
* Risk parity.
* 1/N rule.

Question 25

Discuss factors affecting rebalancing policy.

Answer 25

The following indicate wider corridors for asset classes:
* Higher transaction costs.
* Higher investor risk tolerance.
* Higher correlation of the asset class with the rest of the portfolio.
* Higher volatility of asset classes indicates a narrower corridor to control risk.

Question 26

Discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as constraints on asset allocation.

Answer 26

Portfolios that are too small may be unable to invest in alternative investment vehicles.

Portfolios that are too large may find it difficult to invest in niche strategies.

The asset owner’s liquidity needs should be matched to the liquidity characteristics.

During periods of negative returns evaluate liquidity requirements.

Longer time horizons typically allow for greater risk exposure.

As time passes the asset allocation must be regularly revisited.

Question 27

Discuss tax considerations in asset allocation and rebalancing.

Answer 27

Taxation reduces the risk and return of assets but leaves asset correlations unaltered.

Lower after-tax risk levels lead to wider rebalancing ranges for taxable investors.

Frequent rebalancing leads to realized taxable gains.

Assets taxed at higher effective rates should be allocated first to tax advantaged accounts.

Question 28

Recommend and justify revisions to an asset allocation given change(s) in investment objectives and/or constraints.

Answer 28

Asset allocations should be reviewed in the light of changing goals, beliefs, or other constraints.

Asset allocations may change automatically along a predetermined glide path.

Question 29

Discuss the use of short-term shifts in asset allocation Tactical Asset Allocations (TAAs).

Answer 29

Systematic TAA: uses quantitative signals to dictate shifts in weightings.

Discretionary allocation: relies on qualitative interpretation of data and manager skill in identifying shorter-term trends.

TAAs aim to enhance returns by altering asset classes, sectors, or risk-factor premium weightings.

The performance of TAAs can be measured by comparing realized portfolio results with TAA implemented to what would have happened under SAA.

Success is indicated by a better Sharpe ratio, information ratio, or t-statistic of the excess returns.

TAAs can result in excessive trading and tax costs and in the concentration of risk.

Question 30

Identify behavioral biases that arise in asset allocation and recommend methods to overcome them.

Answer 30

Loss aversion: occurs when a dislike of losses and preference for gains distorts rational decision making. Use goals-based investing to mitigate.

Illusion of control: is an overestimation of one’s ability to control events. Start with the CAPM market portfolio and use sound corporate governance to mitigate.

Mental accounting: subjectively (not rationally) treats different pools of funds differently and often leads to suboptimal asset allocation. Use goals-based investing to mitigate.

Representative (recency) bias: overemphasizes the importance of the most recent events and can lead to trend following, assuming what is currently happening will continue. Use sound corporate governance to mitigate.

Framing bias: can result in suboptimal decisions when the way information is presented affects the decisions made. Start with a full range of relevant information to mitigate.

Availability, familiarity, and home bias: are closely related. What is easily recalled or available is given too much importance in the decision process. Start with the CAPM market portfolio to mitigate.