Asset Allocation Strategies

Question 1

What is asset allocation?

Answer 1

• Asset allocation is the process of how to distribute capital among different asset classes.
• A focus on asset allocation is justifed as investment theory says investors are only rewarded for non-diversifiable or systematic risk, i.e. beta.
• Systematic risk cannot be diversified away but we can remove non-systematic risk by mixing asset classes.

Question 2

Why is asset allocation important?

Answer 2

• Various academic articles have show why asset allocation is so important:
  
  • Hood and Beehower examine the investment of 91 large US pension plans in the 70s and found that asset allocation explained 94% of the variation in total plan return.
  • Kaplan found that 90% of the variability in returns of a typical US fund across time is explained by the funds asset allocation

Question 3

What is strategic asset allocation?

Answer 3

• Before setting the SAA we need to find out what the clients objective is, this can be done through a fact find and should give a clear rationale for investment decisions. Without one we do not know what we are going to do.
• The objectives might be return, risk and timescale. Based on these we can think about the SAA of a portfolio.
• First we need to model asset classes and the risk and return that we might expect.
  
  • If we think that the future will be like the past then we can bootstrap the data.
  • if not, then we can use sampling technques with similar risk and returns as the past.
  • If not, then we need to make estimates for the future.
• SAA needs to be based on the client and needs to be a mix of market expections (efficent frontier) and investor risk tolerance and investment constraints.
• The mix should have the aim to remove diversifiable risk via diversifcation.
• SAA can be static or dynamic
  
  • Static may not be sufficent to adapt to changing market conditions.
  • Dynamic might mean to many changes that can be costly.

Question 4

What is dynamic asset allocation?

Answer 4

• DAA is used when we have a liability to be met.
• Divide the portfolio into a risk portfolio and a safe portfolio, one aims for upside and the other for protection.
• The portfolio is rebalanced between the risky asset and safe asset depending on performance of the risk portfolio.
• A common DAA is CPPI in which if a portfolio value falls, more is placed into the safe assets, essentially providing a stop loss but it will remove some of the upside potential.
• The hedge portfolio will hold assets that meet some defined liability.
• Assets will be a good match for the liability so can be nominal or real return.
• The performance portfolio will have the remaining assets and can aim to earn a risk premium and may include leverage but must not endanger the payment of liabilities.
• The performance portfolio will be estimated to have a maximum loss. The amount remaining can be added to the value of the safe portfolio to cover the minimum define value or liability.

Question 5

Define what risk parity portfolio is?

Answer 5

• Risk budgeting is a approach to volatility management and determines which assets you spend your risk budget on.
• This is used when there is no liability to be met as it does not have a stop loss.
• Asset allocation concerns equal contributions of risk, it takes the best risk diversified portfolio and uses leverage.
• It is used because in a typical portfolio of 60/40 bonds, most of the risk comes from the equity allocation and so there is much more risk concentration that capital concentration and the GFC showed that LTAA is less diversified than we thought.
• The aim of risk parity is for a more stable portfolio from a risk concentration perspective.
• Risk parity portfolio usually sit below the CML and so it is often rejected as not efficent and usually has more weight in lower-risk assets.
• Once the maximum risk diversifed portfolio has been identified you can use leverage in the risky sub-portfolio. This can be used to counterbalance lost return associated with holding lower-risk assets. This allows the risk parity portfolio to become more efficient but with less risk concentration.
• However, this assumes that investors can and are willing to use leverage.
• If you cannot manufacture equity like returns then it may be more efficient to hold higher risk assets.

Question 6

What are the merits and drawbacks of risk parity portfolios?

Answer 6

• Merits:
  
  • Puts the focus on portfolio diversification, risk concentration and investment risk control.
  • A smoother, more stable performance should be the result.
  • Chance to earn equity like returns without equity like risk if leverage is used.
  • Presumption is that returns are less predicatable than risk, in the last decade risk has been more successfully predicated as investment returns have been hard to predict.
  • We do not need to forecast expected returns to implement risk parity approach.
  • Leverage counterbalances lost return associated with holding low risk assets.
• Drawbacks:
  
  • Risk parity portfolio is not likely to have the highest sharpe ratio.
  • If investors cannot easily manufacture equity like returns then it may be more efficent to hold more high-risk assets.
  • Leverage will be expensive in a high interest rate enviroment.
  • Too costly to borrow funds given what funds may be expected.
  • Not told when to rebalance to risk parity weights.
  • If markets fall we may miss any liability target as we have not included an amount we cannot afford to lose.

Question 7

What is LTAA?

Answer 7

• Often used where growth is needed and where investor is happy to bear the risk through volaility.
• Reflects a belief that the investment objective will be met.
• Designed to see through short-term volatility and deliver on a future objective.
• LTAA is usally efficently set be a mean-variance optimisation porcess.

Question 8

What are the merits and drawbacks of LTAA?

Answer 8

• Merits
  
  • ​Suitable for when investor is happy to bear long-term risk and continue through ups and downs.
  • Inexpensive in terms of trading costs since rebalncing is only periodic.
  • Suitable is you want a more passive approach.
  • Does not require intensive management.
  • Good where a large investor who has an aspriational investment objective that is likely to be met but who can afford for it not to be.
• Drawbacks
  
  • ​Not adaptive to changing market conditions.
  • Don’t know when to rebalance.
  • Do we chose a discipline rule or do we choose human interpretation of information and data?
  • If there is a liability, there is an element of luck whether or not this is met.
  • It focuses on meeting a long-term objective on average, but if bad returns happen then may not achieve objective.
  • Actual weights of the portfolio move about and may not be delivering on the most efficient asset mix.
  • Max asset class weight will exist just before the drop in the value, if you rebalance then you are investing more in assets that have lower prices and taking from higher price assets.

Question 9

Define what CPPI is?

Answer 9

• Used when there is a liability to be emt such as a deposit for a house or retirement amount such that an investor wishes to preserve an amount of capital but still make a gain.
• It is a method of portfolio insurance where the investor sets a floor on the value of the portfolio, then structures asset allocation around that decision.
• Divides the portfolio into two sub-portfolios; a risky sub-portfolio of growth assets and then a safe sub-portfolio of short-term government bonds such as treasuries.
• The capital of the portfolio is moved between the two sub-portfolios depending on the performance of the risk sub-portfolio.

Question 10

What are the merits and drawbacks of CPPI?

Answer 10

• Merits:
  
  • ​Useful when there is a lump sum such as a deposit or house and an investor wishes to preserve and not lose a certain amount.
  • does not forgo growth as still have risky portfolio
  • No leverage so there is less risk
  • CPPI invests more in assets that have risen in value and that may rise again. And invests in assets that have dropped in value and that may drop again.
• Drawbacks:
  
  • ​The process stops a loss relative to the floor, but it also takes away some upside potential.
  • CPPI sells into a falling market rather than buying into a falling market.
  • Following a fall CPPI has little exposure to the upside when the market rises again.
  • The cushion is rebuilt very slowly after maximun expected loss

Question 11

What is an asset liability Model?

Answer 11

• The investor creates two sub-portfolios.
  
  • The safe portfolio is the hedge portfolio. Whatever markets do this will hold sufficient assets to meet all the liabilities taking into account expected return.
  • The risky portfolio holds the other assets. Performance of these assets could be totally wiped out, but the liability is still met. This allows you to go for very risky performance and can even include leverage so long as this does not inhibit the liability.
    
    • The portfolio can be leveraged until a max loss event + repayment of borrowing = zero.
    • The size of probability of the max loss event will determine how much assets we have in each portfolio. The more confident we are then the more assets go into the risky portfolio.

Question 12

What are the merits and drawbacks of ALM?

Answer 12

• Merits:
  
  • ​Allows for a future liability to be met with certainty while not foregoing upside due to the creation of a performance portfolio, meaning that not all of the assets have to be in the safe portfolio.
  • Use of leverage can make the portfolio more efficent and make up for the loss return.
  • Use of leverage allows the investor to go for risky sources of return and know that the liablity or will still be met.
  • Liability can be invested in inflation-linked bonds to protect the liability.
  • As we do not rebalance between the two portfolios, costs can be lower as we are only changing the performance portfolio.
• Drawbacks:
  
  • ​Will not have the max sharpe ration or on the efficent set of portfolios
  • The use of leverage can only be applied if the investor has stated so in the IPS
  • Can get expensive if interest rates rise
  • Max loss event may be larger than expected.

Question 13

What is risk premia approach?

Answer 13

• Risk premia aims to maintain risk exposures constant and diversifed at the portfolio level. Asset allocation stems from total portfolio risk rather than at a specifc level of assets classes such as equity, bonds ect.
• By doing so an investor is able to avoid the pressure to buy or sell an asset at non-preferable times just in order to stay close to allocation strategies.
• Idea is to balance risk premia you are getting paid for.

Question 14

What are the merits of risk premia approach?

Answer 14

• Merits​
  
  • A result of thinking about drivers is that these become a focus in the investment allocation to identify the underlying drivers. Such as fixed income like high yield debt and emerging market debt may be more correlated to equities than to government bonds. This is a problem as although they are in different, they act similar. An IM with allocation to high yield or convertibles is much more equity allocation than asset class buckets suggests.
  • To move beyond this, it you can move to different labels such as growth, defensive and uncorrelated and this is why have been adding alternatives.
  • Designed to manage risk exposures and not asset class labels and the aim is to control value or risk not the value of asset class. Risks such as liquidity, leverage, and currency can be managed at the total portfolio level.
• Drawbacks​
  
  • Many elements may be new for the team and board/trustee.
  • Models needed to build a risk premia strategy would likely require new skills from those existing employees and if not done carefully this could cause cultural problems.
  • May not be the resources to gather and analyse the data appropriately.
  • The complexity of trying to predict this can come at a cost to the client.
  • Critical issues is the ability of members to understand the strategy and the complexities of thinking beyond asset class labels and if it goes wrong then can this can be explained.

Question 15

What are the implemenation issues of a risk premia approach?

Answer 15

• Are there any cultural issues in moving to risk premia?
• Over what period of time do we need to implement the transitions.
• Do we need to change the structure of the team and what pedagogy is needed to convince the board.
• Would take time to move over
• Potential impact on client returns as the transition happens.
• Increased costs of transitioning and running a risk premia approach would need to be passed on to clients or absorbed.
• The liquidity may not be there in the asset to run the risk premia approach and that may constrain the diversification achieved and increase risk.
• Team needs to agree on what the return drivers will be and the ability to put time into them.
• High level investment model would be needed to guide the factor information to understand the behaviour of the return drivers.