Asset Allocation

Question 1

Explain the function of strategic asset allocation in portfolio management.

Answer 1

Strategic asset allocation combines capital market expectations with the investor’s risk, return, and constraints (from the IPS). Strategic asset allocation is long term in nature, and the weights are called targets and the portfolio represented by the strategic asset allocation is a policy portfolio, or target portfolio, or benchmark.

Question 2

Discuss the role of strategic asset allocation in relation to specifying and controlling the investor’s exposures to systematic risk.

Answer 2

Each asset class has its own quantifiable systematic risk, and strategic asset allocation is a conscious effort to gain the desired exposure to systematic risk via specific weights to individual asset classes. Each asset class represents relatively similar investments (e.g., long-term corporate bonds) with similar systematic risk factors. Exposure to specific asset classes in specific proportions enables portfolio mangers to effectively monitor and control their systematic risk exposure. In other words, strategic asset allocation reflects the investor’s desired systematic risk exposure.

Question 3

Compare strategic and tactical asset allocation.

Answer 3

Tactical asset allocation is the result of active management wherein managers deviate from the strategic asset allocation to take advantage of any perceived short-term opportunities in the market. Hence, tactical asset allocation introduces additional risk, which should be justified by additional return, often called alpha.

Question 4

What is dynamic asset allocation?

Answer 4

Dynamic asset allocation takes a multi-period view of the investment horizon. It recognizes that asset (and liability) performance in one period affects the required rate of return and acceptable level of risk for subsequent periods. Static asset allocation ignores the link between optimal asset allocations across different time periods. Investor who undertake the asset-liability approach to strategic asset allocation typically prefer dynamic asset allocation to static asset allocation.

Question 5

Asset classes have been appropriately specified if:

Answer 5

1. Assets in the class are similar from a descriptive as well as statistical perspective.
2. They are not highly correlated so they provide the desired diversification.
3. Individual assets cannot be classified into more than one class.
4. They cover the majority of all possible investable assets.
5. They contain a sufficiently large percentage of liquid assets.

Question 6

Using mean-variance analysis, how would you decide whether to include an additional asset class in an existing portfolio?

Answer 6

Using a decision rule based on the the new investment’s Sharpe ratio, the current portfolio Sharpe ratio, and the correlation of the returns on the two. If the Sharpe ratio of the new investment is greater than the Sharpe ratio of the current portfolio multiplied by the correlation of the new investment’s returns with the portfolio’s returns, adding the investment to the portfolio will improve the portfolio Sharpe ratio.

Question 7

What does empirical research suggest about the standard deviation of currency vs. the standard deviation of stocks.

Answer 7

The standard deviation of currency is only about half the standard deviation of stock prices. It is the less important determinant of risk.

Question 8

Compare the volatility of an investor’s position in non-domestic assets with the sum of the volatility of the local market return (LMR) and the local currency return (LCR)

Answer 8

The correlation of LMR and LCR is generally less than +1.0. Therefore, the volatility of the investor’s position will be less than the sum of the volatility of the LMR and LCR. The more the correlation of LMR and LCR approach -1.0, the lower the volatility of the investment for the investor.

Question 9

What are the cost in international assets?

Answer 9

1. Transaction cost.
2. Tax witholding may not be fully offset by tax treaties.
3. Free-float can be an issue.
4. Inefficient market infrastructure.

Question 10

What may explain the rise in correlation with international assets during financial crises?

Answer 10

1. Markets becoming less segmented and more integrated.

2. Industry factors becoming more important than country factors in determining a company’s risk and return.

Question 11

What are the benefits of international diversification?

Answer 11

1. Foreign markets could be undervalued and, thus, offer better expected returns.
2. While the investor’s home market may have had the best returns in the past, that is not a reliable indicator of future returns.
3. Even if correlations rise in the short run during crises, the long-run benefits of diversification can remain.
4. Correlations among bond markets tend to be lower than among equity markets. Adding international bonds to domestic-only portfolios can be particularly beneficial in reducing risk for risk averse investors.

Question 12

What is one explanation against the notion that correlations rise during financial crises.

Answer 12

Part (but not all) of the rising correlation can be explained away by technical issues in the way correlation is calculated; the mathematics of calculating correlation bias the statistic upward as standard deviations rise.

Question 13

What are the special considerations of emerging market investing?

Answer 13

1. Investability: Liquidity & free float can be limited.
2. Non-normal return distributions which are inconsistent with mean-variance assumptions.
3. Strong economic growth may not benefit existing shareholders: Share dilution, high share prices, weak corporate governance, opportunities allocated by the government.
4. Contagion.
5. Currency devaluation.
6. Inefficient markets

Question 14

Explain the effects on share prices, expected returns, and return volatility as a segmented market becomes integrated with global markets.

Answer 14

1. Equity share prices rise: Investability increases allowing capital inflow and declining stand alone risk.
2. Expected returns increase as capital flows into the market but then declines after the initial inflow to be consistent with the now higher stock prices and lower risk..
3. Long-run volatility should decline as the markets become more efficient.
4. Diversification benefits decline as correlation and covariance with the world market increases.
5. Market microstructure and efficient improve.
6. Capital cost fall with high stock prices and lower risk.

Question 15

What is the mean-variance frontier?

Answer 15

The outer edge of a graphical plot of all possible combinations of risky assets.

Question 16

What is the efficient frontier?

Answer 16

The portion of the mean variance frontier that contains portfolios with the highest expected return at each level or risk.

Question 17

What is the mean-variance optimization approach (MVO)?

Answer 17

MVO is a static 1-period model and assumes that inputs will remain constant over time. MVO identifies at each level of return the portfolio with the lowest standard deviation and the asset allocation for that portfolio. The efficient frontier then starts with the portfolio with the lowest standard deviation and rises to the right.

Question 18

Is there a risk-free rate and how does it lead to the concept of CALs and CMLs?

Answer 18

Over a single, discrete time period it is generally possible to identify a risk-free asset with a know return, zero standard deviation, and correlation to other asset returns of zero. The CAL is a line between the risk-free asset and the tangency portfolio (portfolio with the highest Sharpe Ratio) while the CML is the line between the risk-free asset and the market portfolio of risky assets. If an investor can borrow and lend at the risk-free rate the investor can construct any portfolio on the CML and these optimal portfolios dominate the otherwise optimal portfolios on the efficient frontier (EF).The market portfolio is the only portfolio common to the CML and EF.

Question 19

What are the conceptual and practical problems with using the CML to construct an SAA?

Answer 19

1. For the multiple and often ongoing time periods of a typical portfolio there is not risk-free asset. The single period government security will have a changing return over time and a standard deviation of the return.
2. Even if a risk-free asset existed for a client concerned only with a single period, there are practical problems if the client is seeking a return higher than the market; the CML would require borrowing on an ongoing basis to take a leveraged position in the market. Generally borrowing creates risk and imposes restrictions that are unacceptable for most investors as a long-term strategy.

Question 20

What is a significant drawback to generating an efficient frontier through traditional mean-variance optimization?

Answer 20

The sensitivity of the frontier to changes in the inputs. Especially since the inputs themselves are estimates.

Question 21

What is the resampled efficient frontier (REF)?

Answer 21

A simulation approach utilizing historical means, variances, and covariances of asset classes, combined with capital market forecast. The resampling technique is based on a Monte Carlo simulation that draws from the distributions to develop a simulated efficient frontier. Because the simulation is run thousands of times, the efficient portfolio at each return level, and hence the resulting efficient frontier, is the result of an averaging process. Rather than a singe, sharp curve, the resampled efficient frontier is a blur. There can be many different combinations (by varying weights) of a given set of assets that will yield the same expected return and standard deviation, so the computer is asked for many sets of mean-variance efficient portfolios (a resampled efficient frontier) using the same set of returns and standard deviations. The average weight for each asset are used to represent the weights of the asset in the resampled efficient frontier.

Question 22

What advantages does resampling have over the traditional MVO?

Answer 22

1. It utilizes an averaging process that generates a more stable efficient frontier. Small changes in inputs only result in small changes in the resampled efficient frontier.
2. Portfolios generated through resampling tend to be better diversified.
3. Because there are multiple portfolios on the resampled efficient frontier for a level of risk it is possible that the current portfolio lies within the boundaries of what is acceptable leading to less portfolio turnover and lower transaction costs.

Question 23

What are the disadvantages of the resampled efficient frontier?

Answer 23

1. Its lack of a sound theoretical basis. There is no theoretical reasoning to support the contention that a portfolio constructed through resampling should be superior relative to another constructed through traditional mean-variance analysis.
2. The inputs are often based on historical data that could lack current relevance.

Question 24

Give a general description of the Black-Litterman model (BL).

Answer 24

It starts with the weighs of asset classes from a global index. Applying a Bayesian process, the manager increases or decreases the weights based upon her views of expected asset class returns and the strengths of those views. Unconstrained allows for short sales (negative weights).

Question 25

What are the specific steps for the Black-Litterman (constrained) model (BL)?

Answer 25

1. Select a relevant, global market index. Input the market weights for the asset classes in that index and a covariance matrix for those classes.
2. Use reverse optimization to back-solve for the implied, expected returns of those asst classes. Having started with a market index and the market’s weighting, these will be market consensus return expectations.
3. The manager then reviews the implied returns and expresses any opinions regrading the returns and the strength of those opinions.
4. The manager then resets any implied returns up or down to reflect the manager’s opinions and conviction level.
5. A new MVO is run using the adjusted returns where the manager had an opinion and the market consensus return where the manager has no opinion. The new MVO produces the recommended asst mix.

Question 26

What is the Asset Liability management (ALM) approach?

Answer 26

The ALM approach searches for the set of allocations, which maximize the difference (the surplus) between assets and liabilities at each level of risk.

Question 27

Given a group of corner portfolios, which one will approximate the market portfolio?

Answer 27

The corner portfolio with the highest Sharpe ratio will approximate the market portfolio.

Question 28

What is the capital allocation line (CAL)?

Answer 28

The CAL is the straight line drawn from the risk-free rate to the tangency portfolio on the efficient frontier, where the tangency portfolio is the corner portfolio with the highest Sharpe ratio.

Question 29

Given a risk-free rate and assuming no constraint against leverage, how would you determine the asset allocation given a group of corner portfolios.

Answer 29

Chose the tangency portfolio (portfolio with the highest Sharpe ratio. Find the weights that equate the tangency portfolio and the risk-free rate to the required return. Use the weight for the tangency portfolio to determine the weight for each asset class in the tangency portfolio.

Question 30

Given a risk-free rate and assuming a constraint against leverage (margin not allowed), how would you determine the asset allocation given a group of corner portfolios.

Answer 30

In the situation where using margin is not allowed, the investor will combine the two corner portfolios adjacent to the required return. Find the weights that equate the two corner portfolios to the required return. Use the weights for each corner portfolio to determine the weight for each asset class in the each portfolio.

Question 31

What is tactical asset allocation (TAA)?

Answer 31

TAA involves short-term deviations from the strategic asset allocation in an attempt to capitalize on capital market disequilibria (mispricing).

Question 32

Explain Dynamic asset allocation.

Answer 32

Dynamic asset allocation takes a multi-period view of the investment horizon. It recognizes that asset performance in one period affects the required rate of return and acceptable level of risk for subsequent periods.Dynamic asset allocation is difficult and costly to implement. Usually preferred by those who take the ALM approach.

Question 33

Explain the key assumption of the Black-Litterman approach in forming market expectations.

Answer 33

Key assumption: Financial markets are in equilibrium.

Question 34

How do you determine whether adding an investment to your current portfolio will increase it’s risk adjusted return.

Answer 34

Add an investment top the portfolio is the Sharpe ratio of the investment is higher than the product of the Sharpe ratio of the current portfolio and the correlation between the investment and the current portfolio.

Question 35

Describe expected return estimation bias associated with traditional mean-variance allocation and describe a method that can be used to help solve the problem.

Answer 35

The inputs to traditional mean-variance allocation includes expected returns, standard deviations, and correlations. The expected return bias arises from the requirement to estimate expected returns. The Black-Litterman approach is the only model that does not start with estimating expected return. Using a reverse-optimization process, expected return is back-solved. The analyst must still react to the implied, market consensus returns, and bias is still possible, but the analyst must explicitly deal with market consensus expectations, which would help to mitigate biases.

Question 36

Explain conditional return correlation and its implication on asset allocation in the construction process.

Answer 36

Conditional return means that correlation is dependent upon the amount of volatility in the global market at any point in time. Evidence has shown that global markets become more highly correlated during times of crisis, with correlation decreasing after the crisis. Global markets have also become more correlated as they become more integrated. In response, portfolios can be constructed using a conditional correlation calculated based on the magnitude of return instead of assuming correlation will be constant. The portfolio will be optimized using the conditional correlations reflecting both normal and abnormal market conditions.

Question 37

What is the approximate standard deviation of a portfolio composed of two corner portfolios?

Answer 37

The weighted average of the standard deviations of the two corner portfolios.