Asset Allocation Strategies

Answer 1

1. Fact find
2. From this we can set an objective
   
   1. Before we set out on investment we need to articulate where it is going, when and how.
   2. An investment objective provides a clear rationale for investment decisions and without one there is no basis for what is trying to be acheived.
   3. This might be expressed at a return, a risk.
   4. Once we know what level of return and risk is acceptable we can then look at strategic weights.
3. We need to model asset classes
   
   1. If we think that historic returns are a good predictors then historic data can be used
   2. If we think it will be a good guide we can bootstap the data
   3. If not we could use interpretive scenarioes
4. Then to determine the asset allocation we want to use mean variance optimisation
   
   1. This involves identifying the different asset calsses and their relative proportions that shoud deliver the required rate of return of the investment objective at an acceptable level of risk.
   2. Asset allocation is generally undertaken with a long-term investment horizon. This is SAA and is one of the most important parts of portfolio constructions.
5. Then you decide on whether to use SAA and this needs to be based on client circumstances.
   
   1. SAA combines capital market expectations and investors risk tolerance and investment constraints.
   2. A broad asset mix is justified based on investment theory that you are only awarded for non-diversifable risk, that is, systematic risk.
   3. The asset mix is a key tool to manage the risk of any fund via diversification.
   4. SAA can be static or dynamic.

Answer 2

Annualised return (12

Answer 3

• Merits:
  
  • Risk target puts the focus on portfolio diversification, risk concerntration and investment risk control. A smooth more stable performance should result.
  • Portfolio will be close to maximum sharpe ratio
  • Chance to earn equity-like returns without taking equity like risk if leverage is used.
  • In recent decades risk has been more succesffuly predicted than returns.
  • Do not need to implement expected returns to implement risk parity approach.
  • Concentrating your risk may pay of and most people are betting on equities but that do not know what range is likely. With risk parity your are positioning in the middle so that you arent to focused.
• Drawbacks:
  
  • The risk parity portfolio will rarely be the ghighest sharpe ratio portfolio.
  • If investors cannot easily manufacture equity like returns then it may be more efficient to use the optimal portfolio.
  • The leverage might not work in a high interest rate enviroment as it may be too costly to to borrow the funds.
  • Just like long term asset allocation we are not told when to rebalance back to risk parity weights.
  • If markets fall we may miss any liability target as we have not incorporated an amount we cannot afford to lose.

Question 4

Provide a synopsis and apprasial of Long-term asset allocation?

Answer 4

• often used where growth is desired and where investor is happy to bear the risk through ups and downs.
• Reflects a belief that the investment objective will eventually be met but is not used to automatically adaptive to changing conditions.
• No idea when to rebalance.
• Do we choose human interpretation of information and data?
• Designed to see through the short-term and deliver on a future objective,
• LTAA is usually efficiently set by a mean-variance optimisation process.
• Inexpensive in terms of trading costs if rebalancing is only periodic.
• Suitable if you want more passive approach.
• Actual weights move about and may not be delivering on the most efficient asset mix.
• But doing nothing then maximum asset class weight will exist just before the drop in the value. If you rebalance then investing more in assets that have lower price and taking from higher price asset.
• If there is a liability, with a long-term asset allocation there is an element of luck whether or not we meet our liability.
• Perhaps better suited to an investor who has an aspirational goal that is likely to be met but who can afford for it to be lost.
• Merits:
  
  • Suitable for when investor is happy to bear long-term risk and continue through ups and downs.
  • Reflects a belief that the investment objective will eventually be met.
  • Designed to see through the short-term and deliver on a future objective.
  • Inexpensive in terms of trading costs since rebalancing is only periodic.
  • Suitable is you want more passive approach.
  • Does not require intensive management.
  • Good where a large investor who has an aspirational investment objective that is likely to be met but who can afford for it not to be.
• Drawbacks:
  
  • Not adaptive to changing conditions.
  • Don’t know when to rebalance.
  • Do we choose the discipline of a rule? Do we choose human interpretation of information and data?
  • If there is a liability, there is an element of luck whether or not we meet the liability.
  • If focuses on meeting a long-term objective on average, but if bad returns happen the outcome may fall short.

Question 5

Provide a synopsis and appraisal of CPPI?

Answer 5

• Sypnosis:
  
  • Useful when there is a liability to be met such as a deposit for a house or retirement amount.
  • Investor wishes to preserve and not lose a certain amount.
  • CPPI is mean to preserve an amount of capital and 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.
  • Done by dividing the portfolio into two sub-portfolios a risky sub-portfolio of growth assets and a safe sub-portfolio of short-term government bonds such as treasuries and other stable value assets.
  • The capital of the portfolio is move between the risk and safe sub-portfolios depending on the performance of the risk sub-portfolio.
  • We sell into falling market rather than buying into a falling market.
  • CPPI invests more in assets that have risen in value and may rise again and less in assets that have dropped in value and may drop again.
  • The process stops a loss relative to the floor, but it also takes away some upside potential.
  • Following a fall CPPI has little exposure to the upside when the market rises again.
• Merits:
  
  • Useful when there is a lump sum such as deposit or house and an investor wishes to preserve and not lose a certain amount.
  • Does not forgo capital against by being only in safe assets
  • No leverage so there is less risk.
  • Preserves an amount of capital and can still make a gain.
  • Is a method of portfolio insurance as investor sets a floor on the dollar value then structures asset allocation around that decision?
• Drawbacks:
  
  • CPPI removes more and more upside potential if need to protect the capital.
  • It stops a loss but it also takes away some upside potential.
  • The cushion is rebuilt very slowly after maximum expected loss.
  • May miss market rises that follow large drops.

Question 6

Provide a sypnosis of ALM?

Answer 6

• Sypnosis:
  
  • Create two sub-portfolios. The safe portfolio is the hedge portfolio or protection portfolio. Whatever markets do this will hold sufficient assets to meet all the liabilities taking into account expected return. This is then left. These assets will be left to match the liability.
  • Capital is not moved between the 2 sub-portfolios.
  • The second sub-portfolio is the performance with the remainder of the assets. Performance of these asset 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 des not inhibit the liability.
  • We leverage the performance portfolio until a maximum loss event + repayment of borrowing = zero. All that remains is the assets in the protection portfolio. The level of confidence we like about the maximum loss event. The more confident we want to be of covering it the more into the tail of the distribution we go, the higher the maximum expect loss and the less we put into the risk sub portfolio or the less several we use in the ALM.
• Merits:
  
  • Allow 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 asset have to be in the safe assets.
  • Use of leverage can get some profile as the efficient or highest Sharpe portfolio to make up for the lost return. Use of leverage allows the investor to go from very risk sources of performance and know that the liability or safe portfolio will not be impacts as the performance portfolio max loss plus leverage plus borrowing = zero.
  • Liability is usually 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:
  
  • Drawback is that the asset liability approach will not be at the max Sharpe ration or on the efficient set of portfolios.
  • The use of leverage can only be applied if the investor has stated so in the IPS.

Question 7

Provide a sypnosis of risk premium?

Answer 7

• Sypnosis:
  
  • SAA puts things into buckets and limits ability to deviate from weights so takes away some flexibility.
  • Risk premia approach aims to maintain risk exposures constant and diversified the portfolio at the level of risk and return streams rather than at the level of specific asset classes such as equity, bond, real estate or infrastructure.
  • By doing so an investor is unable to avoid the pressure to buy or dispose of illiquid investments at non-preferable times just in order to stay close to allocation targets.
  • Instead an investor can look through asset class labels to assess risk and make decisions accordingly.
  • Idea is to balance risk premia you expect to get paid for.
• 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.
• Implementation issues:
  
  • 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.