Asset Allocation Flashcards
"a explain the function of strategic asset allocation in portfolio management and discuss its role in relation to specifying and controlling the investor’s exposures to systematic risk; b compare strategic and tactical asset allocation; c discuss the importance of asset allocation for portfolio performance; d contrast the asset-only and asset/liability management (ALM) approaches to asset allocation and discuss the investor circumstances in which they are commonly used; e explain the advanta
Asset Allocation
- Process and Result
Two types:
Strategic
Tactical
Strategic Asset Allocation (SAA)
Investor’s IPS elements are integrated with long term capital market expectations to establish exposure to IPS permissible asset classes
- Process with well defined steps which leads to having weights for asset classes
- Starting point
Tactical Asset Allocation
-Short term adjustments to asset class weights based on short term expectations
Role of SAA in relation to systematic risk
- Specifies the investors desired exposure to systematic risk
- SAA exercises and controls the systematic risk exposure
- Sets a benchmark
- Appropriate asset mix to be held under long term normal conditions
SAA VS TAA
SAA/TAA
Long Term/Short Term
/Active management choice
Reviewed periodically/
Empirical Importance of Asset Allocation
- Fraction of variation in returns over time attributable to asset allocation
- Proportion of variation among funds’ performance explained by funds’ different asset allocation –> Cross sectional importance
Approaches to SAA
- Asset Only
- Asset Liability Management
Asset Liability Approach
- Modelling liabilities and adopting optimal asset allocation in relation to funding those liabilities
Used for those who have future liabilities (DB plans) or Quasi Liabilities
Quasi Liabilities
Future income needs
Asset Only
-No modelling of liabilities
- Much less precision in controlling risk related to funding liabilities
Approaches to ALM
- Risk minimizing
- Accepting surplus risks to be benefit from surplus return
Risk Related approaches
- Cash flow matching approach
- Immunization
Cash flow matching approach
- Invests in bonds to match future liabilities/quasi liabilities
Immunisation
- Structures investment in bonds to offset the weighted average duration of liabilities
- More risk than cash flow matching approach
- To better manage risk, managers match both convexity and duration
Other approach to ALM
Static
Dynamic
Dynamic Approach
- Actual asset allocation and actual asset return and liability in given period affect the optimal decisions that will be available in the next period
- Worth it for ALM approach
Static Approach
- Does not consider links between optimal decisions at different times
Difference of asset allocation between ALM and AO approach
- ALM results in higher allocation to fixed income securities
Investors who prefer ALM approach
- Below average risk tolerance
- penalties for not meeting the liabilities or quasi liabilities are high
- MV of liabilities or quasi liabilities are interest rate sensitive
- risk taken in the investment portfolio limits the investors ability to profitably take risk in other activities
- legal and regulatory requirements and incentives favour holding fixed income securities
- tax incentive favour holding fixed income securities
Return Objective and SAA
- Returns both quantitative and qualitative
- Should have a quantitative return objective stated for SAA
- Return = Spending rate , inflation, cost to earn the rate and the compounding effect
- If an arithmetic mean rate is given it should be compounded upward
- Multistage period to be considered - dynamic is a better approach
Risk objective and SAA
- Risk aversion
- Standard deviation
- Short fall risk
- Downside risk
Risk aversion
- Ability and willingness to take risk
- High risk tolerance - lower risk aversion
Measuring the utility using risk aversion
Uofm=E(Rofm)-0.005R(av)variance of(m)
Standard deviation
- accepting certain level of volatility measured by standard deviation
Shortfall risk
- Type of downfall risk
- risk that the portfolio’s value will fall below the minimum acceptable level
- Roy’s safety first criterion
Roy’s safety first criterion
- SFration = E(Rp)- R(l)/standard deviation of P
- Choose a portfolio with higher SFration
Behavioural Influences on Asset allocation
- loss aversion
- mental accounting
- regret avoidancw
Loss aversion
- Worry more about avoiding losses than gaining
- Risk-seekers when faced with situations of substantial loss
- Dealing with these investors:
a. short fall risk approach
b. ALM approach
Mental accounting
- Investors put mone in different buckets without considering the correlation between them and hence no effecient - no overall perspective taken into consideration.
- Suggested approach: multistrategy goal based asset allocation.
- Criticism of the approach: Ignores correlation
Time consuming and expensive to optimize
Regret aversion
Implications
- psychological factor promoting diversification
- regret avoidance may limit divergence from peer’s avg asset allocation
Asset Class - Criteria
- Homogenous
- Mutually Exclusive
- Diversifying
- Make up a preponderance of world investable wealth
- Capacity to adopt a significant fraction of portfolio’s without affecting liquidity
Traditional Asset Classes
- Domestic Common Equity
- Domestic Fixed Income
- Non-domestic Common Equity
- Non-domestic Fixed Income
- Real Estate
- Cash and cash equivalents
The inclusion of International Assets
A new asset class should be added if the following condition is met
E(Rnew-Rf)/std. dev of new is greater than [E(Rp-Rf)/std. dev of p))*Corr(Rnew,Rp)]
The above criteria is not valid if the distribution of the proposed assets class return in non-normal
Issues to consider:
1. Currency risk
2. Increased correlation in time of market crashes
3. Emerging Market Concerns - limited free float of shares, nondomestic ownership - limited, quality of company info, non-normality of returns
Alternative Investments
- lack of correlation between the different assets within the alternative investment class
- lack of information like equity and bond
- Fees and expenses related are higher
Steps in Asset allocation
- Diagram in Text: Pg 230
