Asset Allocation with Real-World Constraints

Question 1

Contrast smaller funds vs larger funds (in terms of asset size) when choosing an Optimal Asset Allocation

Answer 1

Smaller funds : often lack the expertise and governance structure to invest in complex strategies, and therefore, often face a problem of how to achieve an adequate level of diversification. In addition, many capital markets impose local legislation, restricting investment in some assets to investors with a given level of capital or experience.

Larger funds : Larger portfolios can generally access greater management expertise in the governance capacity, allowing them to consider complex strategies that smaller funds cannot. Their larger capital base also enables investment in accounts with relatively high minimum investment requirements. This allows large funds to achieve higher levels of diversification.

Question 2

Define two strategies that can reduce the impact of taxation

Answer 2

Tax loss harvesting : Realize capital gains loss on purpose to offset capital gains elsewhere.

Strategic Asset Allocation : Making the most efficient use of tax advantageous accounts : Tax exempts and tax deferred accounts.

Question 3

Tactical Asset Allocation’s success is based on what kind of bets ?

Answer 3

Short term returns/opportunites are being made by takings bets on market or factor timing, not on individual securities.

Question 4

How can we compare the success of the Tactical Asset Allocation strategy ?

Answer 4

1.Comparing the Sharpe Ratio of the TAA vs SAA

2. Comparing the information ratio or t-stats of the excess realized returns vs SAA
3. Comparing the realized returns of the TAA vs a portfolio lying on the same efficient frontier. It may be less optimal that similar risk portfolio.
4. Perform attribution.

Question 5

Define Loss aversion and how can we overcome this bias.

Answer 5

When investors dislike losses more than they like gains. Whenever returns are negative, it will be hard for them to maintain a discipline approach.

Overcome this bias by using goals based approach to divide our assets based on goals and priority. Higher priority goals will invest in less risky assets.

Question 6

Define Illusion of control bias and how to overcome it.

Answer 6

Tendency to overestimate the ability to control events. Investor will trading more frequently, will use tactical allocation shift too often, above average use of short selling and leverage.

To overcome, we should use the basic CAPM MVO to start with a base and then shifts from the allocation should follow a formal review process.

Question 7

Define mental accounting

Answer 7

Involve seperating assets and liabilities into different buckets. It often leads to suboptimal asset allocation and less chance to meet our goals.

Question 8

Define representative bias/ recency bias

Answer 8

When investors attach more importance to recent data than old data. Exemple, investor will shift their asset allocation towards assets that recently outperformed, thinking that it will continue.

Question 9

Define Framing bias

Answer 9

The way the infomation is presented will affect the resulting decision. Risks can be presented using standard deviation but could be better to present it using another metrics.

Question 10

Define Availability Bias

Answer 10

Events thats occurs in the past that are easier to remember (usually extreme events) will be overweight.

Question 11

Explain why it is more accurate to use an after tax standard deviation for an investor that is not tax exempted.

Answer 11

Capital gains tax lowers the profit you actually keep when an investment’s value goes up. Similarly, you can use losses from investments that went down in value to reduce the tax impact. Because of these tax effects, it’s better to use a “post-tax” risk measure, like a post-tax standard deviation, when deciding how to allocate assets.