Asset Allocation and Portfolio Diversification

Question 1

What are the steps for phase 1 of the asset allocation process?

Answer 1

1) Understand client’s financial position, goals, constraints, and risk-return preferences
2) Educate investor on various strategies and styles to develop realistic expectations
3) Specify goals and policies to be used in managing funds

Question 2

How do you define client’s financial situation?

Answer 2

• Balance sheet: List assets and liabilities on a specific date to calculate net worth
• Cash flow sheet: Determine free cash available per period from all incoming/outgoing cash flow
  -Financial ratios: Describe client’s abilities based on financial situation using various ratios

Question 3

What kind of investments would someone in higher tax brackets want?

Answer 3

Municipal bonds /money market instruments /investments that are tax exempt for income

Question 4

Examples of legal constraints

Answer 4

• Letter stock restrictions for founders of startups that go public
• IRAs governed by rules and regulations set by ERISA, DOL, SEC and IRS
• Trust accounts and charitable donations bound by US law

Question 5

What transactions and illiquid assets require planning and patience to reduce transaction costs?

Answer 5

Real estate, art, municipal/corporate bonds, emerging markets stocks
foreign exchange, large amounts of cash

Question 6

What’s a way to define a client’s investments needs, assess personalities, ascertain goals and gauge risk tolerance?

Answer 6

Questionnaires and using lifecycle asset allocation

Question 7

What’s a good tool to help a client determine risk-return preference?

Answer 7

Capital Market Line, which shows an efficient set of stocks and risk-free borrowing/lending rate

Question 8

Topics to discuss to manage expectations

Answer 8

• What’s realistic and achievable
  -Scope of what portfolio attempts to accomplish
• relationship between risk-return
• market volatility
• difficulty and low success rate of market timing

Question 9

Parts of policy statement

Answer 9

• Benchmark portfolio/market index with historical risk/return statistics
• Constraining policies such as beliefs, preferences or obstacles
• Asset allocation policies: SAA- identifies classes and proportions, then TAA to govern dynamic reallocations, then integrate market timing/security selection
• Panic attack: establish investment guidelines and policies for the long term

Question 10

4 Forecasting) What analyst styles does a portfolio manager’s forecast depend on?

Answer 10

• Fundamental security: studies financial rations, issuer’s products, competition, legislation and other facts to determine a company’s intrinsic value
• Technical: studies historical market data, prepares price graphs, and studies statistics to seek repeating patterns. Usually prepare forecasts for one asset or market index at a time
• Risk-return: studies historical means and variances of return, correlations between investments, and translates data to forecasts. Usually performed on indexes.

Question 11

Phase 2 of asset allocation process

Answer 11

Manage money

Question 12

5) Asset allocation: Components

Answer 12

• simple asset allocation
• constrained asset allocation- manager should consider non-discretionary portion before allocating discretionary portion
• Markowitz Portfolio Theory maximum expected return available at risk level and minimum risk at expected return: lean variant optimization
  -selecting efficient asset allocation

Question 13

When should SAA/TAA be used?

Answer 13

If capital markets are in equilibrium, then follow strategic asset allocation/policy asset allocation/normal asset mix/long-run asset allocation.
If the market is not in equilibrium, then tactical asset allocation, which deviates from SAA may be used

Question 14

6) Investing allocation funds

Answer 14

Via broker, liquidating assets, large asset transaction costs

Question 15

7) Performance reports & feedback

Answer 15

MV for each asset and aggregate value of the portfolio are prepared for clients on a quarterly basis; however if the manager is involved with a dynamic strategy, then the TAA and SAA weights will differ and the portfolio’s return over the last three months is annualized and compared to/will be different from its long-run expected annual return

Question 16

Various asset allocations

Answer 16

• Dynamic asset allocation- alters asset weights according to changes in market conditions or changes in investor’s circumstances
  -Integrated Asset Allocation- uses investors goals and policies and capital market conditions as data inputs into optimizer

Question 17

Mean reversion process

Answer 17

security returns tend to fluctuate randomly in the short run but tend to revert back to their long-run means after attaining extreme values

Question 18

Situations requiring rebalancing

Answer 18

• Time: Gradually more conservative
• Performance: security performance may skew asset allocations

Question 19

How is portfolio diversification achieved?

Answer 19

Eliminating unsystematic (firm-specific/diversifiable) risk by ensuring that securities with extreme returns cancel each other out without affecting the expected return

Question 20

Concentrated Portfolios

Answer 20

Typically have less than 20 different stocks and are less diversified and depend solely on the ability of the portfolio manager.