Asset Allocation

Question 1

What is an economic balance sheet for an individual?

Answer 1

It includes conventional financial assets and liabilities, and extended assets and liabilities relevant in making asset allocation decisions.

Extended assets:
* include human capital (PV of future income)
* the PV of inheritance capital.

Extended liabilities: include the PV of current consumption.

Question 2

What is the extended portfolio for institutional investors?

Answer 2

Extended assets:
* PV of intellectual property
* underground mineral rights.

Extended liabilities: future unpromised payments to grantees (i.e., grants payable appears on a conventional balance sheet).

Question 3

What are the 6elements of effective governance and investment governance considerations in asset allocation?

Answer 3

1. Short- and long-term objectives.
2. Use knowledge, capacity, time, and hierarchy position
3. Establish processes for developing the IPS
4. Establish processes for developing/approving SAA
5. Establish framework for reporting and monitoring
6. Periodically perform a governance audit

Question 4

What are the investment objectives of asset-only, liability-relative, and goals-based asset allocation approaches?

Answer 4

Asset-only: Allocation focuses on assets without regard to liabilities. Maximize Sharpe.

Liability-relative (LDI): Allocation focuses on payment of liabilities as they come due and asset-only investment of surplus assets.

Goals-based (GBI): Allocation addresses subportfolios that focus on investor goals as if they were liabilities. Subportfolios distinct risk/return requirements and constraints.

Question 5

What are the concepts of risk relevant to asset-only, liability-relative, and goals-based asset allocation approaches?

Answer 5

Asset-only: Volatility (standard deviation) and correlation to optimize risk and return.

Liability-relative: Shortfall risk to avoid underfunding liabilities.

Goals-based: Maximum acceptable probability of not achieving a goal to avoid underfunding goals.

Question 6

How are asset classes used to represent exposures to systematic risk?

Answer 6

An investor optimizes the risk-return tradeoff by diversifying idiosyncratic risk of a particular investment.

Exposure to the systematic risk (the only risk compensated) of that diversified portfolio can be personalized by investing in different asset classes exhibiting different returns, standard deviation of returns, and correlations with other asset classes.

Question 7

What is the criteria for asset class specification?

Answer 7

Homogeneous: Similar attributes

Mutually exclusive: A specific asset cannot be included in more than one asset class

Diversifying: A specific asset class should have low correlation with other asset classes or linear combinations of asset classes

Inclusive: Asset classes as a group should include world investable assets

Asset classes selected for a portfolio should be able to absorb available funds without market impact.

Question 8

What are the uses of risk factors in asset allocation and their relation to traditional asset class-based approaches?

Answer 8

Individual asset sensitivities to various risk factors can be used to establish desired exposures to risk factors in a portfolio. Such portfolios may use both long and short positions.

Risk factors, unlike asset classes, are not directly investable. However, they may provide better matching of a liability’s risk exposures than traditional asset classes.

Question 9

What are the types of investors utilizing various asset allocation approaches?

Answer 9

Asset-only: Unclear amount and timing of distributions; endowments and some foundations

Liability relative: Banks, defined benefit pensions, and insurers

Goals-based: Individual investors

Question 10

What is the use of the global market portfolio as a baseline portfolio in asset allocation?

Answer 10

The global market-value weighted portfolio sums all investable assets reflecting a supply-demand balance across world markets. This portfolio minimizes non-systematic risk, which is theoretically uncompensated.

Therefore, this portfolio makes best use of an investor’s available risk budget and should be used as the baseline portfolio in optimization.

Question 11

What is tactical asset allocation (TAA) and dynamic asset allocation (DAA) in implementing strategic asset allocation (SAA)?

Answer 11

Tactical asset allocation (TAA): involves an active decision to vary from the SAA to exploit short-term deviations from expected long-term relationships. These decisions might
* capture price momentum
* perceived asset class valuation discrepancies
* a stage of the business cycle

Dynamic asset allocation (DAA): involves an active decision to vary from the SAA based on longer-term economic conditions or valuation signals.

Question 12

What are passive/active SAA implementation choices?

Answer 12

Passive implementation results in investment selection that does not react to CME changes or insights into individual investment as does active management.

Question 13

What are some passive/active SAA implementation vehicles.

Answer 13

Passive investing: can be implemented through a tracking portfolio designed to replicate returns to an asset class.
* exchange-traded fund (ETF)
* mutual fund

Active investing: can be implemented through a portfolio of securities that reflects the investor’s perceived special insights and skill and makes no attempt to track an asset-class index’s performance.

Question 14

What are the main strategic considerations in rebalancing asset allocations?

Answer 14

Rebalancing, part of the revision process, aligns actual portfolio weights with the SAA.

The need for rebalancing results from changing asset values, investor circumstances, or CME estimates.

Failing to rebalance allows the highest-return assets to dominate a portfolio, effectively negating the long-term diversification and risk-return optimization.

Question 15

What are the ranges for strategic considerations in rebalancing asset allocations?

Answer 15

Wider rebalancing ranges:
* higher transactions costs
* illiquidity
* taxability of returns
* momentum

Tighter rebalancing ranges:
* lower transactions costs
* client risk aversion
* lower correlation with other classes
* mean reversion

Synthesis with derivatives can lower the rebalancing costs of an asset class.

Question 16

What is mean-variance optimization (MVO)?

Answer 16

MVO provides a framework for maximizing expected return at a given level of expected risk, thereby allowing an investor to optimize their risk budget.

Greater risk aversion results in higher λ.

Question 17

What are the 3 issues using mean-variance optimization (MVO) in asset allocation?

Answer 17

1.) Asset allocations present high asset class concentration or diversified classes but concentrated sources of risk.

2.) Does not address:
* trading costs
* evolving allocation strategies
* path-dependent decisions
* non-normal distributions.

3.) Is a single-period framework with no consideration of taxes or rebalancing costs.

Question 18

What is the interpretaion and critique an asset allocation in relation to an investor’s economic balance sheet?

Answer 18

Consider the weights for recommended asset classes in the context of correlations with human capital or the liability for future spending.

Question 19

What are some consideration in asset class liquidity considerations in asset allocation?

Answer 19

Large institutions can invest in illiquid asset classes without jeopardizing liquidity.

Individual investors may have insufficient assets for the risk involved or to qualify as accredited investors.

Substitute liquid assets with returns highly correlated to the illiquid class.

Substitute liquid assets with sensitivities to risk factors represented in the illiquid assets.

Question 20

How do clients needs and preferences regarding investment risks can be incorporated into asset allocation?

Answer 20

Express each investor goal as a:
* need
* want
* wish
* dream
and assign importance expressed as a probability of achieving.

An investor may come to the table with “labeled” goals representing investment features such as:
* purchasing power preservation
* growth of capital
* risk level

Identify asset requirements available to each goal and manage each as a subportfolio.

Question 21

What is risk budgets and risk budgeting in implementing an asset allocation?

Answer 21

A risk budget is a specific allocation of portfolio risk to an asset class, factor, etc.

Risk budgeting describes the process of finding an allocation of risk across assets or asset classes that optimizes return for the desired risk.

Question 22

What is absolute risk budgets in determining and implementing an asset allocation?

Answer 22

An absolute risk budget limits the absolute contribution to total risk (ACTR) for an asset class as a function of its beta and the portfolio variance, or marginal contribution to risk (MCTR).

Question 23

What is the use of absolute risk budgets in determining an asset allocation?

Answer 23

Optimal risk budgeting occurs when excess return for each asset class divided by its MCTR is the same across all asset classes, meaning the same excess return per unit of systematic risk employed for that asset (Sharpe ratio).

Question 24

What is a liability-relative risk budgets in determining and implementing an asset allocation?

Answer 24

A liability-relative risk budgeting method first determines the liability PV and then establishes its surplus and funding ratios.

Decreasing the discount rate results in higher PV of Liabilities and decreases the surplus.

Question 25

What is the use of Monte Carlo simulation (MCS) and scenario analysis to evaluate the robustness of an asset allocation?

Answer 25

MCS provides a better viewpoint toward uncertainty, including a return distribution, than scenario analysis, which varies several variables in a more discrete way.

That probability distribution can then be used to establish success or failure of a subportfolio (probability of achieving each goal).

Question 26

What is the use of investment factors in constructing and analyzing an asset allocation?

Answer 26

Liability cash flows depends on inflation and future economic conditions (impossible to fully hedge all).

The best approach select assets reflecting the underlying risk sensitivities of the liability portfolio.

For ongoing pension plans, government-sponsored inflation-linked bonds provide a robust hedge against future inflation and economic changes.

Question 27

What are the return-sensitivities across various asset classes?

Answer 27

• Size: small-cap stock versus large-cap stock
• Valuation: value stock versus growth stock
• Momentum: winners versus losers
• Liquidity: low liquidity versus high liquidity
• Duration: long term versus short term
• Credit: low-rated bonds versus highly rated bonds
• Volatility: low-volatility stocks versus high-volatility stocks

Question 28

What is the asset allocation decision process based on the global market portfolio?

Answer 28

The global market portfolio is value weighted based on market capitalization, and it prices only systematic risk.

The global portfolio, assumed to be tangent to the efficient frontier at some level of risk, can then be combined with a risk-free asset to improve return outcomes at a given risk level.

Question 29

What are the 7 characteristics of liabilities that are relevant to asset allocation?

Answer 29

• Fixed versus contingent cash flows
• Legal liabilities versus quasi-liabilities
• Duration and convexity of liability cash flows
• Value of liabilities as compared with the size of the sponsoring organization
• Factors driving future liability cash flows
• Timing considerations, such as longevity risk
• Regulations affecting liability cash flow calculations

Question 30

What are the uses of surplus optimization to establish a risk budget for an asset allocation?

Answer 30

Substitute surplus return, volatility, and risk aversion in the utility model, which reflects MVO outcomes subject to legal, regulatory, and policy constraints.

A correlation coefficient between assets and liabilities measures the relationship between their values. The asset most correlated to the liabilities dominates when surplus is small, gradually declining in portfolio weight as surplus grows.

Question 31

What is the use of hedging/return-seeking portfolios to establish a risk budget for an asset allocation?

Answer 31

This method separately manages the surplus optimization portfolio, which may use surplus optimization, from the liability hedging portfolio, which is constructed using cash-flow matching, duration matching, or immunization.

This approach is limited when the funding ratio is less than 1.

Question 32

What are he less conservative approaches to managing the hedging portfolio in a hedging/return-seeking strategy?

Answer 32

Partial hedge: The liability portfolio is not fully funded in the hope of greater return and lower required sponsor contributions or improved income from the plan.

Dynamic hedge: The investor increases funding to the hedging portfolio along a “glide path” as the funding ratio increases.

Question 33

What is the use of an integrated asset-liability approach to establish a risk budget for an asset allocation?

Asset-liability management (ALM)

Dynamic financial analysis (DFA)

Answer 33

Institutions and long-short hedge funds (short position is a liability) use this approach to simultaneously determine both asset and liability portfolio composition.

ALM’s competing goals are maximizing surplus growth subject to constraints on worst-case and other risk measures.
Unlike hedging/return-seeking, however, the liabilities can also be managed.

Question 34

What is the recommendation and justification of a liability-relative asset allocation?

Answer 34

The best outcomes are achievable with multi-period integrated asset-liability models.

The single-period models (surplus optimization and the two-portfolio approach) do not adequately consider the risks of meeting future obligations.

Question 35

What is the “120 minus your age” rule?

Answer 35

It recommends the percentage of stocks in a client’s portfolio. It considers the client’s age, ability to take risks, time horizon, and diversification.

The rule motivates creation of target-date funds, which systematically rebalance stock/bond weights over time.

Question 36

What is the “60/40 stock/bond” rule?

Answer 36

It states that clients should skip asset allocation optimization and simply hold 60% stock and 40% bonds.

Question 37

What is the endowment model (Yale model)?

Answer 37

An approach emphasizing a large allocation to alternative investments and active traditional asset management.

The strategy seeks to earn illiquidity premiums over the long horizons, which makes this strategy less viable for late-stage investors.

Question 38

What is a risk parity asset allocation?

Answer 38

Diversification is achieved by equating risk across all asset categories.

A major weakness of the model is that it ignores expected returns.

Question 39

What is the 1/N rule?

Answer 39

It is a simple and naive rule where an equal weight is assigned to each asset or asset class.

Empirical studies have found that the 1/N rule performs better in terms of Sharpe ratios.

Question 40

What is an appropriate rebalancing policy?

Answer 40

Appropriate policy balances the benefits (reduction of losses due to tracking risk) and the costs of rebalancing.

Additionally:
* Rebalancing earns a diversification return; compound growth rate is greater than the weighted average compound growth rates of the component portfolio holdings.
* Rebalancing earns a return from selling short volatility.

Question 41

What are some issues of small asset size as a constraint on asset allocation?

Answer 41

Small AUM may not be able to properly diversify into:
* emerging markets
* private equity
* hedge funds
* direct real estat
* ownership
* infrastructure

Regulatory constraints may impose restrictions against smaller investors (private placements, private equity, hedge funds).

Some funds may require a minimum investment in the tens of millions.

Question 42

What are some issues of large asset size as a constraint on asset allocation?

Answer 42

Large AUM may need to:
* pursue ideas outside their core expertise
* invest in multiple active funds
* suffer market impact when conducting large trades.

Larger organizational hierarchies may slow down decision making.

Question 43

What are some issues of liquidity as a constraint on asset allocation?

Answer 43

A proposed asset allocation should anticipate the owner’s future needs, especially during times of stress.

Liquidity needs vary inversely with predictability of outflows.

More liquidity is necessary when governance boards lack the will to hold longer-term, illiquid investments through market downturns.

Question 44

What are some issues of time horizon as a constraint on asset allocation?

Answer 44

As human capital (which has bond-like qualities) declines over time, an investor must replace it with bonds.

The term structure of a liability changes as it approaches maturity (duration shortens until the requirement becomes cash-like).

The character of assets and liabilities change over time.

Question 45

What are some issues of regulatory factors, taxes, and unique circumstances as constraints on asset allocation?

Answer 45

Companies or funds subject to regulation and may have a limited investment set or have capital limits on risk asset classes.

Tax-exempt status may require certain spend minimums.

Individual investors may have ongoing funding or liquidity events related to children or parents.

Question 46

What are some tax efficiency considerations in asset allocation and rebalancing?

Answer 46

Some asset classes are more tax efficient than others. Generally, investors should place less tax-efficient assets in tax-advantaged accounts.

After-tax portfolios are less volatile and therefore afforded wider rebalancing ranges than pre-tax portfolios.

Question 47

What are realized capital losses in asset allocation and rebalancing?

Answer 47

No uniform treatment exists for considering embedded tax liabilities in asset allocation.
You can adjust a portfolio’s current value as if all assets were liquidated and the tax impact realized.

Capital losses can offset a current capital gain or in some cases carry forward against future realized gains.

Rebalancing approaches should attempt to minimize tax drag.

Question 48

What is tax loss harvesting in rebalancing?

Answer 48

Involves realizing a capital loss to offset a current or future realized capital gain in another part of the portfolio.

Question 49

Why would there be a need for revisions to an asset allocation given change(s) in investment objectives and/or constraints?

Answer 49

Investor objectives, constraints, and capital market expectations drive an optimal asset allocation.

Changes in: may require a new allocation.
* personal circumstances (marriage, children, or illness)
* risk appetite
* capital market expectations
* Changes in regulatory constraints or tax laws

Question 50

What is and how is Tactical asset allocation (TAA) used for short-term shifts in asset allocation?

Answer 50

Tactical asset allocation (TAA): seeks to earn additional return by underweighting or overweighting asset classes relative to the policy portfolio based on qualitative political, economic, and financial market conditions (discretionary TAA) or quantitative signals (systematic TAA).

The important distinction is the human professional input in discretionary TAA.

Question 51

What are the methods to evaluate TAA performance against the SAA?

Answer 51

Results of the TAA may be compared against the SAA for:
* Sharpe ratio
* information ratio
* t-statistics of the average excess return.

Plotting the realized return and risk of the TAA portfolio versus the realized return and risk of portfolios along the SAA’s efficient frontier may also yield important information.

TAA can increase transactions costs and tax drag for a portfolio, so after-tax comparisons are appropriate.