Ch 8 Analysing Portfolios Flashcards
Glide Paths vs STatic Asset Allocation
Sequencing Risk
Sequencing Risk: if you have a lot in equities and suffer a severe market downturn it can be very hard to make up the value later in life
Glide Paths vs STatic Asset Allocation
A static asset allocation tailored to one’s risk appetite for the vast majority of their life has been shown in simulation to be superior to glide paths
Layering for Safety
- Paper authored by Challenger – Meeting the Financials Needs of Retirees: a layering approach to building retirement income portfolios
- Idea is to use several products to have a high chance of minimum income & a lower chance of exceeding that
Layering for safety - basic vs more sophisticated option
- Basic option
- use lifetime annuity to provide the additional income to meet the min requirement
- Top up income - by drawing down capital (residual from retirement savings) - More sophisticated
- additional income add growth bucket which is converted to income at later age
Non Linear Returns (4)
● Assets w/ non linear returns may be ignored by MV optimisers, MAY BE INCLUDED where another measure of risk is used to address non linear payoff
● Optimiser still gives extreme solutions. Still assumes all parameters of distribution are known.
● Mitigate estimation error with stein estimators, resampling, ensuring similarities with benchmarks..
● Dynamic asset allocation strategies target particular risk
● Portfolio insurance (usually option replication)
● Constant Proportion Portfolio Insurance (CPPI) (NOT IN EXAM)
● Run scenarios
● Different weights of eq vs eq option; generate stats (return, SWD, then LPM0, LPM1, LPM2.
• LPM0: Probability that return is below target
• LPM1: Shortfall
• LPM2: Semi variance
Insured Asset Protection (Portfolio Insurance)
- nOTE FROM sample in notes
● NOTE: Often the effect of the option is not worth the price; need to assess client’s intention; assess probability of protected portfolio out/underperforming the non protected portfolio.
Insured Asset Protection (Portfolio Insurance) Consider long time horizon - example of LT horizon - Tactical protection - currency
● Super fund has long time horizon
● Tactical use of protection: protect against expected adverse market movement (active management)
● Strategic use: consistent use of derivatives to protect would reduce both risk and return.
● Currency over long term: strategic hedging of currency – unhedged returns have higher volatility even though E(R) offshore assets is the same whether or hedged or not hedged. Currency hedging therefore might make sense over longer term.
• Other considerations: presence of liabilities in different currencies; diversification; transaction costs (though FX costs normally low)
● To include augmented (non linear) strategies, need the efficient frontier to move up and to the left.
Glide Paths
- concept
- modeling shows..
● Concept: AA should aim for high returns when young and safer portfolios towards retirement
● Modelling in spreadsheets shows not much difference in probability of survival of the fund
Booms / Busts
- impact differs when..
- testing
● Different amount of $$ invested has disproportionate impact in times of boom or bust
● Testing with historical data: maintain historical order of original series
● Testing with random data: use block bootstrap method; with specified block length. Long block length – eg 10 years – simulate boom/bust. Block size 1: complete randomness (no booms/busts)
Meeting Financial Needs Paper
- Stages of wealth
- Retiree spending requirements
● Accumulation: grow capital (subject to risk) via contribution and investment returns
● Retirement: Need to generate cashflows
● Mathematical approach / age-phasing of risk taking in AA
● Sustainable withdrawal rate: proportion of retirement savings a retiree could safely spend/yr
• Rule of thumb: 4% of k in 1st yr -> increase spending w/ infl each yr. Small chance of no k after 30 years
● Goals based investing / partial annuitisation
● Retirement spending requirements:
● Income for essentials
● Discretionary spending
● Health/aged care costs
● Bequest
Meeting Financial Needs Paper
- Retiree risks
- Market risk
a. Sequencing risk “the risk from a market downturn is at its greatest when the capital invested in the market is at its largest (portfolio size effect).” - Inflation risk
- Longevity risk
- Other
a. Behavioural risk (eg behaviour differs from plan)
b. Public policy risk
Meeting Financial Needs Paper
- Layers
- Age pension – note as assets are depleted, the means test allows pension part payment / full payment
- Defined benefit pension (not available to all)
- Lifetime annuity (cover gap between pension & min spending requirements. Can have inflation indexation)
a. Only needs to cover gap between min income required and the age pension + other income - Variable Annuity
- Add additional layers: in early years of retirement: growth bucket (uses longer time frame)’ which transitions to income-producing assets for later stage of retirement. Only works where there are assets available after setting min income level. Min income level is critical/starting point.
