CAIA L2 - 3.5 - Other Asset Allocation Approaches Flashcards
Interpret
Core-satellite approach
3.5 - Other Asset Allocation Approaches
- core (risk-averse) portfolio - strategic asset allocation - low-cost, passive indice
- satellite (risk-seeking) portfolio - tactical asset allocation - actively managed. Active pursuit of alpha
Risk can be customized in that an asset class (eg. venture capital) could be a core asset for one investor and a satellite asset for another
3.5 - Other Asset Allocation Approaches
Interpret
Risk Buckets
3.5 - Other Asset Allocation Approaches
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
Formula
Total risk of a portfolio
(function of factor contributions)
3.5 - Other Asset Allocation Approaches
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
Define
Risk Parity
3.5 - Other Asset Allocation Approaches
- 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
Define
leverage aversion theory
and
volatility anomaly
and
betting against beta
3.5 - Other Asset Allocation Approaches
- 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
List
3 common criticisms
for
risk parity strategy
3.5 - Other Asset Allocation Approaches
1. Future x Past - Historic returns may not be a reasonable basis for assuming that low-volatility strategies will outperform moving forward. relationships may change because historical returns/relationships are also subject to change.
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
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
Market-Weighted Strategy - same weights of market cap. Hard to calculate alternatives mkt cap - individual and total. Difficult because alternative market cap is hard to estimate.
Market-Weighted Strategy = naïve asset allocation strategy, allocators use a 1/N weighting scheme. 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.
Minimum volatility strategy - mean variance optiomazation that selects weights, such that the smallest possible volatility is realized.
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
Define
New investment model
3.5 - Other Asset Allocation Approaches
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
Bottom-up approach vs top-down approach
LO 3.5.2
A bottom-up approach focuses on fund-level or security level analysis. Can create concentrated portfolios.
A top-down approach analyzes macroeconomic considerations. May not be accessible if superior investments are not accesible in a macro-sourced subclass.
A Mixed approach merges bottom-up with top-down, but diversification can revolve around factors and not correlations.
Many funds display a lifecycle effect where they invest more through bottom-up when they are new and gradually evolve to top-down as they mature.
Define risk budget and explain how it is used by asset allocators
LO 3.5.3
A risk budget is an aggregate risk constraint at the portfolio level. Asset allocators can categorize exposures into risk buckets and then seek optimization of returns after risk constraints have been met.
Could lead to a core-satellite approach in which a portion of the risk budget is allocated to the pursuit of alpha as long as the aggregate risk constraint is not violated
Risk can be allocated using a factor-based approach. Discuss some of the strengths and weaknesses of this approach.
LO 3.5.4
The primary strength of factor-based risk allocation is the ability to target
specific risk exposures. This could be beneficial for merger arbitrage,
convertible arbitrage, and global macro funds.
Some weaknesses include a lack of access to some factors on a global scale, impairment due to limits on short selling, and some risk factors that are really bundles of risk factors. The last weakness could make factor targeting more challenging.
