Asset Allocation

Question 1

Asset Allocation

Answer 1

• Process and Result
  Two types:
  Strategic
  Tactical

Question 2

Strategic Asset Allocation (SAA)

Answer 2

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

Question 3

Tactical Asset Allocation

Answer 3

-Short term adjustments to asset class weights based on short term expectations

Question 4

Role of SAA in relation to systematic risk

Answer 4

• 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

Question 5

SAA VS TAA

Answer 5

SAA/TAA
Long Term/Short Term
/Active management choice
Reviewed periodically/

Question 6

Empirical Importance of Asset Allocation

Answer 6

• 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

Question 7

Approaches to SAA

Answer 7

• Asset Only
• Asset Liability Management

Question 8

Asset Liability Approach

Answer 8

• 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

Question 9

Quasi Liabilities

Answer 9

Future income needs

Question 10

Asset Only

Answer 10

-No modelling of liabilities
- Much less precision in controlling risk related to funding liabilities

Question 11

Approaches to ALM

Answer 11

• Risk minimizing
• Accepting surplus risks to be benefit from surplus return

Question 12

Risk Related approaches

Answer 12

• Cash flow matching approach
• Immunization

Question 13

Cash flow matching approach

Answer 13

• Invests in bonds to match future liabilities/quasi liabilities

Question 14

Immunisation

Answer 14

• 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

Question 15

Other approach to ALM

Answer 15

Static
Dynamic

Question 16

Dynamic Approach

Answer 16

• 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

Question 17

Static Approach

Answer 17

• Does not consider links between optimal decisions at different times

Question 18

Difference of asset allocation between ALM and AO approach

Answer 18

• ALM results in higher allocation to fixed income securities

Question 19

Investors who prefer ALM approach

Answer 19

• 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

Question 20

Return Objective and SAA

Answer 20

• 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

Question 21

Risk objective and SAA

Answer 21

• Risk aversion
• Standard deviation
• Short fall risk
• Downside risk

Question 22

Risk aversion

Answer 22

• 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)

Question 23

Standard deviation

Answer 23

• accepting certain level of volatility measured by standard deviation

Question 24

Shortfall risk

Answer 24

• Type of downfall risk
• risk that the portfolio’s value will fall below the minimum acceptable level
• Roy’s safety first criterion

Question 25

Roy's safety first criterion

Answer 25

- SFration = E(Rp)- R(l)/standard deviation of P - Choose a portfolio with higher SFration

Question 26

Behavioural Influences on Asset allocation

Answer 26

- loss aversion - mental accounting - regret avoidancw

Question 27

Loss aversion

Answer 27

- 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

Question 28

Mental accounting

Answer 28

- 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

Question 29

Regret aversion

Answer 29

Implications - psychological factor promoting diversification - regret avoidance may limit divergence from peer's avg asset allocation

Question 30

Asset Class - Criteria

Answer 30

- Homogenous - Mutually Exclusive - Diversifying - Make up a preponderance of world investable wealth - Capacity to adopt a significant fraction of portfolio's without affecting liquidity

Question 31

Traditional Asset Classes

Answer 31

- Domestic Common Equity - Domestic Fixed Income - Non-domestic Common Equity - Non-domestic Fixed Income - Real Estate - Cash and cash equivalents

Question 32

The inclusion of International Assets

Answer 32

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

Question 33

Alternative Investments

Answer 33

- 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

Question 34

Steps in Asset allocation

Answer 34

- Diagram in Text: Pg 230