CAIA L2 - 3.5 - Other Asset Allocation Approaches

Question 1

Interpret

Core-satellite approach

3.5 - Other Asset Allocation Approaches

Answer 1

• core portfolio - strategic asset allocation - low-cost, passive indice
• satellite portfolio - tactical asset allocation - actively managed

3.5 - Other Asset Allocation Approaches

Question 2

Interpret

Risk Buckets

3.5 - Other Asset Allocation Approaches

Answer 2

Organize assets into categories (or buckets) and then fill each bucket up to the parameters specified through the risk budget
(standard deviation of returns, standard deviation of tracking error, value at risk, and beta)

3.5 - Other Asset Allocation Approaches

Question 3

Formula

Total risk of a portfolio
(function of factor contributions)

3.5 - Other Asset Allocation Approaches

Answer 3

Total risk of a portfolio =
sum of factor contributions (correl * vol * beta)
σp = (ρF1 × σF1 × b1) + (ρF2 × σF2 × b2 ) + (ρε × σε)

3.5 - Other Asset Allocation Approaches

Question 4

Define

Risk Parity

3.5 - Other Asset Allocation Approaches

Answer 4

• Idea: equalize marginal risk contributions
• Consequence: high weight on low risk (bonds usually overweight vs stocks)
• Result: low-risk portfolio + potential high sharpe
• Opportunity if high sharpe: use leverage, because:
  “levered risk parity portfolio should outperform an unlevered high-risk portfolio”

Steps:
1. Define risk - ex: VaR, vol
Because risk parity does not impose a uniform definition of total risk, this value needs to be defined. Common options are volatility and value at risk (VaR). For alternative investments, the VaR has the advantage of accounting for skewness and kurtosis.
2. Factor for marginal risk
Risk parity requires measurement of the marginal risk contribution. This is the rate at which an additional unit of an asset would change the risk profile of the portfolio.
3. Determine portfolio weights (trial-and-error)
Calculating portfolio weights is a trial-and-error process, such that

3.5 - Other Asset Allocation Approaches

Question 5

Define

leverage aversion theory
and
volatility anomaly
and
betting against beta

3.5 - Other Asset Allocation Approaches

Answer 5

• Theory: large numbers of investors are averse to portfolio leverage
• Result: avoidance of low-volatility assets (volatility anomaly) => turn them underpriced => high sharpe
• History suggests it worked, but has weakened

Betting against beta
- low beta also was undesired => underpriced => outperforms

3.5 - Other Asset Allocation Approaches

Question 6

List

3 common criticisms
for
risk parity strategy

3.5 - Other Asset Allocation Approaches

Answer 6

1. Future x Past - Historic returns may not be a reasonable basis for assuming that low-volatility strategies will outperform moving forward. Bond yields are currently very low, which may reduce the likelihood of strong price performance in the coming periods.
2. Funding liquidity risk is the likelihood of not having capital available to fund a strategy. When market stress is high, an investor may have reduced access to leverage and even need to de-lever. This reduces the ability to leverage up a low-volatility strategy to maximize Sharpe ratios.
3. Extension to alternatives? There have not been any studies that support that the low volatility or betting against beta anomalies can be extended to alternative asset classes.

3.5 - Other Asset Allocation Approaches

Question 7

Define

Market-Weighted Strategy

Equally Weighted Strategy

Inverse Volatility-Weighted Strategy

Contrast with risk parity, considering volatility and correlation of the assets

3.5 - Other Asset Allocation Approaches

Answer 7

Market-Weighted Strategy - same weights of market cap. Hard to calculate alternatives mkt cap - individual and total.

Market-Weighted Strategy = naïve asset allocation strategy. Reasons to be used:
1. When volatilities and correlations are equal, this method will minimize portfolio risk.
2. It is easy to apply when forecasts are difficult to make.
3. This approach works well when long-term mean reversion is likely.

Inverse Volatility-Weighted Strategy In this formula, the numerator is the inverse volatility (1 / σ) for asset i, and the denominator is the aggregate inverse volatility of the portfolio.

vol equal + correl equal => 4 strategies same result
vol equal + correl unequal => inverse vol weighting + equal weighting - same weights
vol unequal + correl equal => inverse vol weighting + risk parity - same weights

3.5 - Other Asset Allocation Approaches

Question 8

Define

New investment model

3.5 - Other Asset Allocation Approaches

Answer 8

Separation of pursuit:
1. beta (strategic allocation)
2. alpha (tactical allocation / usage of alternatives)
3. portable alpha (alpha from location different from where beta is located)

3.5 - Other Asset Allocation Approaches