CAIA - 01 - Asset Allocation Processes and the Mean-Variance Model Flashcards
Whether asset allocation or security selection has the greatest impact on portfolio performance depends on what two factors?
Diversified vs concentrated
Definition of performance
There are 3 key questions regarding the importance of asset allocation for the performance of diversified portfolios:
- How much return variability is explained by ___ ___ ?
- How much of the difference in average returns between diversified funds is explained by differences in ___ ___ ?
- What part of a fund’s ___ return is explained by its ___ ___ policy?
There are 3 key questions regarding the importance of asset allocation for the performance of diversified portfolios:
- How much return variability is explained by asset allocation?
- How much of the difference in average returns between diversified funds is explained by differences in investment policies?
- What part of a fund’s average return is explained by its asset allocation policy?
Most studies find that ___ - ___% of variation in diversified traditional portfolios is explained by overall asset allocation decisions.
Most studies find that 85-90% of variation in diversified traditional portfolios is explained by overall asset allocation decisions.
Most studies find that less than 50% of the difference in average returns can be explained by differences in asset allocation. The remaining differences are explained by factors such as asset-class ___, s___, s___ s___, and f___.
Most studies find that less than 50% of the difference in average returns can be explained by differences in asset allocation. The remaining differences are explained by factors such as asset-class timing, style, security selection, and fees.
The five steps for implementing a systemic asset allocation program are:
- Identify asset owners’ ___ and ___
- Develop an ___ ___ ___
- Implement ___ ___ policy described in IPS
- ___ ___ according to optimal weights
- ___ and ___ the investments
The five steps for implementing a systemic asset allocation program are:
- Identify asset owners’ objectives and constraints
- Develop an investment policy statement
- Implement asset allocation policy described in IPS
- Allocate capital according to optimal weights
- Monitor and evaluate the investments
___ funds are funds established by not-for-profit entities that invest supporters’ charitable contributions and use the invested capital to support the activities of an organization.
Endowment funds are fund established by not-for-profit entities that invest supporters’ charitable contributions and use the invested capital to support the activities of an organization.
___ raise funds through charitable contributions and use the capital to fund grants and support charities.
Foundations raise funds through charitable contributions and use the capital to fund grants and support charities.
___ funds have long investment horizons and are not heavily regulated in terms of investment activities, so they can use a broad universe of assets (including alternative assets).
Endowment funds have long investment horizons and are not heavily regulated in terms of investment activities, so they can use a broad universe of assets (including alternative assets).
Like ___ funds, ___ can use a broad universe of assets due to their long investment horizons and light regulation. However, to take advantage of beneficial tax treatments, ___ must distribute a minimum percentage of their assets each year.
Like endowment funds, foundations can use a broad universe of assets due to their long investment horizons and light regulation. However, to take advantage of beneficial tax treatments, foundations must distribute a minimum percentage of their assets each year.
What are the 4 types of pension funds?
National
Private DB
Private DC
Individually Managed Accounts
___ pension funds are established to provide retirement income to a country’s citizens.
National pension funds are established to provide retirement income to a country’s citizens.
For national pension funds, investment decisions are made by ___ ___.
For national pension funds, investment decisions are made by national governments.
___ ___ ___ plans are established to provide pension benefits to private companies’ employees. The employees are promised a specific retirement income based on a number of factors.
Private defined benefit plans are established to provide pension benefits to private companies’ employees. The employees are promised a specific retirement income based on a number of factors.
The ___ ___ directs the management of a private defined benefit plans assets.
The plan sponsor directs the management of a private defined benefit plans assets.
___ ___ ___ funds receive contributions for employees from the plan sponsors, as specified by the plan. Each beneficiary’s assets are managed by the plan sponsor and the employee. The sponsor decides on the list of available asset classes and the employee selects the asset allocation. When the employee retires, they are given the value of their account.
Private defined contribution funds receive contributions for employees from the plan sponsors, as specified by the plan. Each beneficiary’s assets are managed by the plan sponsor and the employee. The sponsor decides on the list of avaialbel asset classes and the employee selects the asset allocation. When the employee retires, they are given the value of their account.
The Broad categories of asset owners are:
- Endowments and Foundations
- Pension Funds
- Sovereign Wealth Funds
- Family Offices
___ ___ ___ funds are established and managed by national governments and invest a country’s income to benefit its citizens
Sovereign wealth funds are established and managed by national governments and invest a country’s income to benefit its citizens
The growth of sovereign wealth funds is linked to increases in prices of ___ ___
The growth of sovereign wealth funds is linked to increases in prices of natural resources
Family offices (are/are not) typically large enough to have access to a full menu of assets.
Family offices are typically large enough to have access to a full menu of assets.
A(n) ___ is a preference that differentiates between optimal and suboptimal solutions.
An objective is a preference that differentiates between optimal and suboptimal solutions.
A ___ is a condition that must be satisfied by any solution.
A constraint is a condition that must be satisfied by any solution.
___ constraints are set by the asset owner and depend on factors such as the owner’s time horizon, liquidity needs, and desire to avoid certain sectors.
Internal constraints are set by the asset owner and depend on factors such as the owner’s time horizon, liquidity needs, and desire to avoid certain sectors.
____ IPS constraints come from market conditions and regulations.
External IPS constraints come from market conditions and regulations.
Asset owners should clearly state their investment objectives in terms of ___ and ___ that are consistent with their risk tolerance levels and current ___ ___ . In addition, objectives need to be consistent with the fact that higher ___ are associated with higher levels of ___ .
Asset owners should clearly state their investment objectives in terms of risks and returns that are consistent with their risk tolerance levels and current market conditions. In addition, objectives need to be consistent with the fact that higher returns are associated with higher levels of risk.
The probability weighted expected return may be expressed as
The probability weighted standard deviation may be expressed as
___ is a measure of satisfaction gained from investment wealth or return
Utility is a measure of satisfaction gained from investment wealth or return
___ ___ is the probability-weighted average utility over all possible outcomes
Expected utility is the probability-weighted average utility over all possible outcomes
A ___ ___ U(*) describes the relationship that converts an investment’s wealth or return into the investor’s level of utility
A utility Function U(*) describes the relationship that converts an investment’s wealth or return into the investor’s level of utility
An investor’s utility may be expressed as a function of ___ W as U(W).
An investor’s utility may be expressed as a function of wealth W as U(W).
If utility functions are concave, then owners are said to be ___ ___.
If utility functions are concave, then owners are said to be risk averse.
An investment’s expected utility may be expressed in terms of its expected return and its variance of returns as:
Larger λ means that the variance has a (greater/less) effect on the expected utility
Larger λ means that the variance has a greater effect on the expected utility
If the λ is 0 then the investor is said to be risk ___
If the λ is 0 then the investor is said to be risk neutral
If the λ is negative then the investor is said to be risk ___
If the λ is negative then the investor is said to be risk seeking
For investments with non-normal returns, the higher-order moments of ___ and ___ should be incorporated in expected utility.
For investments with non-normal returns, the higher-order moments of skewness and kurtosis should be incorporated in expected utility.
What is the utility function in terms of higher-order moments?
What is the utility function in terms of Value at Risk?
What is the utility function used to manage the risk of a defined benefit pension fund
What is the equation for the degree of risk aversion, λ?
What is the utility function of a DB Plan with liability Growth? (Equation)
What are the 3 typical internal constraints for an investment policy statement?
- ___
- ___ ___
- ___and ___limits
What are the 3 typical internal constraints for an investment policy statement?
- Liquidity
- Time Horizon
- Sector and country limits
Does time horizon impact the allocation to commodities?
Yes - since investors will not be able to benefit from commodities’ long-run mean reversion.
What are the 2 main sources of external constraints for an IPS?
- ___
- ___ ___
What are the 2 main sources of external constraints for an IPS?
- Regulation
- Tax Status
The ___ ___ ___ ___ ___ regulates management of private pension funds in the U.S. and the ___ ___ ___ establishes regulations for pension funds in the UK
The Employee Retirement Income Security Act (ERISA) regulates management of private pension funds in the U.S. and the Financial Conduct Authority (FCA) establishes regulations for pension funds in the UK
A typical IPS has seven common elements:
- B___
- O___
- A___ ___
- G___
- M___ ___
- R___ and ___
- S___ ___ ___
A typical IPS has seven common elements:
1. Background
2. Objective
3. Asset Classes
4. Governance
5. Manager Selection
6. Reporting and Monitoring
7. Strategic Asset Allocation
What are the 3 components of an asset class return?
Short-term risk-free rate
Expected Inflation
Risk Premium
___ asset allocation can add value if it is based on thorough analysis so that it incorporates the fact that financial markets are mostly efficient and it is not adversely affected by portfolio turnover costs.
Tactical asset allocation can add value if it is based on thorough analysis so that it incorporates the fact that financial markets are mostly efficient and it is not adversely affected by portfolio turnover costs.
What is the equation for the optimal weight of a risky asset in a portfolio that contains only one risky asset and one riskless asset?
What is the equation for finding optimal portfolios using MVO and liability values?
When the covariance between assets and liabilities, δ, is positive, the fund will hold (more/less) of the risky asset.
When the covariance between assets and liabilities, δ, is positive, the fund will hold more of the risky asset.
The graph of optimal portfolio’s expected returns and standard deviations is referred to as the ___ ___.
The graph of optimal portfolio’s expected returns and standard deviations is referred to as the efficient frontier.
In general, MVO does not generate realistic weights. The issue can be resolved by imposing ___.
In general, MVO does not generate realistic weights. The issue can be resolved by imposing constraints.
What is the equation for a new asset’s hurdle rate?
Return parameters estimated using historical data (are/are not) reliable.
Return parameters estimated using historical data are not reliable.
Given portfolio optimizers’ tendency to generate extreme portfolio weights, the optimizers tend to exaggerate estimation errors and are referred to as “___ ___ .”
Given portfolio optimizers’ tendency to generate extreme portfolio weights, the optimizers tend to exaggerate estimation errors and are referred to as “error maximizers.”
Accuracy of estimated variance-covariance matrices is improved by using ___-___ data.
Accuracy of estimated variance-covariance matrices is improved by using higher-frequency data.
Accuracy of estimated means is improved by using a ___ ___ of data.
Accuracy of estimated means is improved by using a longer history of data.
____-based returns result in smoothed returns, and assets with smoothed returns have ___ return variances and covariances, which result in MVO generating portfolios that ___-allocate to these assets.
Appraisal-based returns result in smoothed returns, and assets with smoothed returns have understated return variances and covariances, which result in MVO generating portfolios that over-allocate to these assets.
The number of required covariance estimates can be reduced using ___ ___.
The number of required covariance estimates can be reduced using factor models.
When using factor models for covariance estimates, covariance is estimated as the relationship between each asset and a number of factors, using the ___ of a factor model.
When using factor models for covariance estimates, covariance is estimated as the relationship between each asset and a number of factors, using the beta of a factor model.
One issue with MVO is that is only considers the first two moments of a return distribution (___ and ___ ) and ignores higher-order moments (___ and ___ ).
One issue with MVO is that is only considers the first two moments of a return distribution (mean and variance) and ignores higher-order moments (skewness and kurtosis).
All else equal, an asset with negative skew has a (higher/lower) expected return than one with positive skew.
All else equal, an asset with negative skew has a higher expected return than one with positive skew.
MVO tends to (overweight/underweight) assets with negative skews.
MVO tends to overweight assets with negative skews.
___ and ___ asset allocation model addresses the issue of extreme portfolio weights generated by MVO and enables historical returns to be adjusted to reflect portfolio manager’s views about future returns.
Black and Litterman asset allocation model addresses the issue of extreme portfolio weights generated by MVO and enables historical returns to be adjusted to reflect portfolio manager’s views about future returns.
The ___ and ___ model starts with the market equilibrium expected returns and is tilted away from the market portfolio in the direction of the manager’s views.
The Black and Litterman model starts with the market equilibrium expected returns and is tilted away from the market portfolio in the direction of the manager’s views.
In practice, investors add (too many/not enough) constraints to the MVO process.
In practice, investors add too many constraints to the MVO process.
Correlation Coefficient (Equation)
