Asset Allocation Flashcards
Effective Investment Governance Models
- Express short-and long-term objectives.
- Allocate decision rights and responsibilities.
- Establish processes for developing the IPS
- Establish processes for developing and approving the SAA.
- Establish framework for reporting and monitoring progress toward objectives and goals.
- Periodically perform a governance audit.
The Extended Portfolio Assets and Liabilities
- Extended Portfolio Assets: Is the present value of future income, pension income, intellectual property, royalties, inheritance, and minerals or resources
- Extended Liabilities: The expected present value of future expected consumption or payouts
Human Capital vs Financial Capital due to Age
- When individual is younger human capital is high, financial capital is low
- When individual is older human capital is low, financial capital is high
Types of Asset Allocation Approaches
- Asset-Only Approach
- Liability-Relative Based
- Goals Based
Asset Only (AO)
- Making asset allocation decision based only on the investor’s assets on the balance sheet.
- Liabilities are not modeled.
- Relevant Risk Measures: The volaility and corelations of the portolfio returns.
Liability Relative
- Accounts for the liability-side of the balance sheet
- Mainly for institution investors, but can be used by individual investors
- Designed to create allocation decisions for when a liability comes due
- Relevant Risk Measures: Not having enough assets in the portfolio when the liabilities come due
Goals Based
- Asset allocation to sub-portfolio (mostly individuals).
- Common goals are retirement, college, charitable gifts, life-style expenses
- Each sub-portfolio will have its own unique asset allocation to meet a specific goal
- The sum of the sub-portfolios is the Strategic Asset Allocation (SAA)
- Potential risk not being able to meet or achieve the investor goal(s)
- Portfolio risk will be a weighted-average of each having its own probabilities associated with them
What Constitutes an Asset-Class
- Homogenous: The asset should have similar attributes from a descriptive and statical perspective
- Mutually Exclusive: Asset cannot be classified in more than one asset class
- Diversification: An asset class should not be highly correlated
- Asset Classes should cover all possible investable assets as a group and should make up a preponderance of the world investable wealth
- Asset classes should contain a sufficiently large amount of liquid assets that has the capacity to absorb a significant fraction of an investor’s portfolio without seriously affecting the liquidity
Strategic Asset Allocation (SAA)
The long-term strategic plan
Has to be Based on:
* Objectives
* Constraints
Tactical Asset Allocation (TAA)
Is an active management strategy that uses a specific sub-asset class short-term deviation to exploit a specific opportunity in the market
Key Issues: cost benefit approach
* Need to incur additional trading and monitoring cost
* May incur capital gains taxes
9 Steps Needed to Select a SAA
- Determine investors objectives, goals, what are they trying to achieve
- Determine the investors risk tolerance
- What is the investment horizon to be used to measure an investors risk requirement and tolerance
- What is the investor tax situation and/or constraints
- Select the asset allocation approach appropriate for the investor
- Specify the asset classes determine the CME
- Develop the potential asset allocation for the investor to consider
- Simulate the results to see if they meet the needs of the client
- Continue until the optimal allocation is determine
Note:
* It needs to monitored regularly to make sure it’s consistent with the client’s IPS.
* Any change in the long-term are incorporated back into the model for potential revision.
Global Market Portfolio
- Represents a highly diversified asset allocation
- Serves as a baseline in an asset-only approach.
- Reflects the supply and demand across world markets.
- Investors can invest in a risk-free asset, a risky asset, and a combination between
- Once we institute the risk-free asset into the efficient frontier there will no longer be a curve linear anchor at the risk-free rate of return
- We can create capital allocation lines series anchored at the risk-free rate, then cut the original efficient frontier at different points
- The slope of any capital allocation line would be the Sharpe ratio
- Market portfolio: The highest part of the line tangent to the efficient frontier
Types of Strategic Choices
- Indexing: Low costs, with some transaction costs (buy/sell, called, defaults). Follows a passive strategy.
- Enhanced Indexing: Cell matching primary risks factors but with fewer securities (in numbers)
- Full Active: Tracking error will increase, but also expected active return, can outperform the index
Strategic Implement Choice
- Available investments.
- Scalability of active strategies.
- The feasibility of investing passively while incorporating client-specific constraints.
- Beliefs concerning market informational efficiency.
- The trade-off of benefits relative to costs and risks of active investing.
- The management costs, trading costs, and turnover-induced taxes in active investing
- Tax status
Rebalancing
May be necessary under 2 conditions:
* Changes to the policy portfolio because of changes in an investor’s investment objectives and constraints, or in long-term capital market expectations.
* Adjusting the actual portfolio to the SAA because asset price changes have moved portfolio weights away from the target weights beyond tolerance limits.
Rebalancing Approaches
- Calendar-based: Rebalances the portfolio to target weights on a periodic basis, such as quarterly.
- Range-based: Sets rebalancing thresholds (trigger points) around target weights.