Asset Allocation Flashcards
What are the five criteria of an asset class?
Assets within an asset class should be relatively homogeneous
Asset classes should be mutually exclusive
Asset classes should be diversifying
The asset classes as a group should make up a preponderance of world investable wealth
Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio
What are the 6 criticisms of Mean-Variance Optimisation?
The outputs (asset allocations) are highly sensitive to small changes in the inputs.
The asset allocations tend to be highly concentrated in a subset of the available asset classes.
Many investors are concerned about more than the mean and variance of returns, the focus of MVO.
Although the asset allocations may appear diversified across assets, the sources of risk may not be diversified.
Most portfolios exist to pay for a liability or consumption series, and MVO allocations are not directly connected to what influences the value of the liability or the consumption series.
MVO is a single-period framework that does not take account of trading/rebalancing costs and taxes.
What are two ways of addressing the criticisms of MVO?
Reverse Optimisation - start with the market portfolio and let the market dictate the expected return, use weights in benchmark to back out implied returns from market benchmark, then input into implied MVO but with restrictions
Black-litterman - Use the reverse optimisation but selectively view adjust those market expected returns from reverse optimisation and add constraints to force min/max allocations by asset class
How do you calculate the risk-adjusted probability ratio?
(Expect return - Required Return) / Standard Deviation
How do you calculate the utility function?
Expected Return - 0.005 x lambda x standard deviation^2
Where lambda is the investors risk coefficient
How do transaction costs effect rebalancing corridors?
The higher the transaction costs, the wider the optimal corridor
High transaction costs set a high hurdle for rebalancing benefits to overcome
How do risk tolerances affect rebalancing corridors?
The higher the risk tolerance, the wider the optimal corridor
High risk tolerance means less sensitivity to divergences from the target allocation
How does the correlation with the rest of the portfolio affect rebalancing corridors?
The higher the correlation, the wider the optimal corridor
When asset classes move in sync, further divergence from target weights is less likely
How does the volatility of the rest of the portfolio affect rebalancing corridors?
The higher the volatility, the narrower the optimal corridor
Higher volatility makes large divergences from the strategic asset allocation more likely
How are high rate tax investors affected rebalancing corridors?
The higher the tax rate, the wider the corridor
For taxable investors, transactions trigger capital gains in jurisdictions that tax them.
What is resampled Mean–Variance Optimisation?
Resampled mean–variance optimization combines Markowitz’s mean–variance optimization framework with Monte Carlo simulation and, all else equal, leads to more-diversified asset allocations.
What are the 5 other approaches to asset allocation?
120 minus your age rule
60/40 stock bond heuristic
Endowment model - overweight alternatives
Risk parity - each asset should contribute the same amount of risk
1/N Rule - all assets have equal weight
What are the 3 portfolio allocation approaches?
Asset only, liability-based, and goals-based
When should a client use a goals-based approach, liability-based approach or asset-based?
A liability-relative asset allocation approach is used to model legal and quasi-
legal liabilities. It is typically used by banks, insurers, and defined benefit pension
plans. It is least appropriate for individual investors.
Asset-only and goals-based asset allocations are typically used for individual
investors.
What are the disadvantages of MCS?
MCS is a complement to MVO, not a replacement for it.
MCS can be used after an asset allocation is selected using MVO or some variation. MCS then simulates how that allocation may perform over time.
