Asset Allocation and Portfolio Diversification Flashcards
Strategic asset allocation (SAA)
The asset allocation process should begin with the development of a strategic asset allocation (SAA). SAA identifies asset classes and the proportions for those asset classes that would comprise the normal portfolio mix for the investor’s stated time frame. SAA can be used as the final basis for investment selection, or it can be enhanced by adding Tactical Asset Allocation (TAA) approach.
strategic asset allocation (SAA) - Derive long-term asset allocation weights
An example of SAA would be a classic 60% stock/ 40% bond portfolio over the long term.
Tactical asset allocation (TAA)
Tactical asset allocation (TAA) comes after SAA, as it involves planning for deviations from normal long term asset allocation. TAA establishes policies to govern dynamic reallocations of a temporary nature. Keep in mind TAA is a high level form of market timing and can result in outperformance or underperformance versus the SAA. After the SAA and TAA plans are complete, market timing or security selection may be integrated into the plans. However, investors cannot begin working on the SAA and TAA plans until a policy statement, listing the objectives of the investor, is created.
An example of SAA would be a classic 60% stock/ 40% bond portfolio over the long term. A TAA add on would suggest moving to 70% stock/ 30% bonds during a period where rising interest rates and strong stock returns are expected for some time. As this view changes, the portfolio would shift back towards the SAA. This can be done on the asset allocation level, sector level, or even security level.
Tactical asset allocation (TAA) - Change in weights to meet temporary market conditions
Phase 1: Written Policy
Phase 1 of the asset allocation process requires a meeting between you, as a financial planner who is providing asset allocation recommendations, and your client, in order to understand his or her objectives for the investment, risk tolerance, and time horizon. You and your client must reach an agreement about how the client’s funds will be managed. Phase 1 of the asset allocation process is not complete until the parties involved have consummated a written agreement about the investment goals and the policies that will be followed in managing the investor’s funds.
The following are steps for phase 1 of the asset allocation process:
Gain understanding of the client’s financial position, goals, constraints, and the investor’s preferences in a risk-return context.
Develop realistic expectations by educating the investor of advantages and disadvantages of various investment strategies and styles.
Create a statement specifying the goals and policies that will be used in managing the client’s funds.
Dynamic asset allocation (DAA)
Dynamic asset allocation (DAA) refers to alterations in the asset weights made in response to changes in the investor’s circumstances and/or changes in the market conditions. TAA is one type of DAA.
Dynamic asset allocation (DAA) - Change in weights to meet a change in investor’s circumstances
Integrated asset allocation
Integrated asset allocation considers the investor’s goals and policies and the capital market conditions, and then uses these data as inputs to some kind of optimizer. The optimizer could be some mathematical formula (constant proportions), or an optimizing computer program to do Markowitz portfolio analysis. The optimizer’s solution becomes the new inputs that are reconsidered along with the investor’s latest goals and policies and most recent market conditions when revising the asset allocation.
Integrated asset allocation - Optimize based on investment goals and market conditions
Rebalancing
Rebalancing is simply the process of bringing portfolio asset class percentages back in-line with the strategic asset allocation policy. This may be done either ad-hoc or more preferably on a set schedule (e.g., at a particular time each year). The net effect is that positions in winning asset classes are sold with the proceeds reinvested in asset classes which have performed less well during the preceding period. The idea is to sell high and buy low – through a disciplined non-emotional methodology.
Control of Volatility
Mean-variance optimization is all about reducing variance (standard deviation) of a portfolio—which includes reducing volatility (variance relative to a benchmark). This is accomplished through diversification both within and across asset classes.
Strategies for Dealing with Concentrated Portfolios
Concentrated portfolios are portfolios which contain investments representing a high percentage of the portfolio (e.g. greater than 10%). High concentrations increase risk and cause a portfolio to be inefficient (NOT mean-variance optimized). The simple solution is to sell the concentrated position and diversify. However, if the value of the position is well above the tax cost, realizing a large gain and paying the tax may not be advisable. So, the question is: How do we reduce risk without realizing a huge taxable gain? There are two primary ways to do this. The first is to use derivatives (e.g., zero cost collar) to lock-in the value. Another option is to pool the large position with holders of different large positions to create a diversified pool (called exchange funds) to be shared by all investors. This is a great option so long as the other holdings collectively create a truly efficient portfolio.
Investment Policy Statements (IPS)
An investment policy statement (IPS) is a document drafted between a portfolio manager and a client that outlines general rules for the manager. This statement provides the general investment goals and objectives of a client and describes the strategies that the manager should employ to meet these objectives. Specific information on matters such as asset allocation, risk tolerance, and liquidity requirements would also be included in an IPS – as well as specific benchmarks against which performance will be measured.
