L3 Reading 3 Flashcards
Proposed asset allocation is developed after
- IPS is constructed
- investment results are simulated over the appropriate time horizon
- risk and return attributes of all possible asset allocation strategies are considered
Decision reversal risk
Risk of reversing investment decisions at the worst possible time, creating maximum loss
Capital Market Expectations
- Expected return
- standard deviation
- correlation
Client IPS Objectives and Constraints
RRTTLLU
- risk
- return
- time horizon
- tax considerations
- legal
- liquidity
- Unique needs/ any other business
Investment Governance Elements
Most models share 6 elements:
1. establish long-term and short-term objectives
2. allocate rights and responsibilities
3. specify processes for creating an IPS
4. specify processes for creating an SAA
5. apply a reporting framework to monitor progress towards the stated goals and objectives
6. periodically perform a governance audit
Extended portfolio assets
for individuals
- PV of expected earnings (human capital)
- PV of pension income
For institutions
- PV of royalties and exploitable resources
Extended liabilities
For indviduals
- PV of expected future consumption
For institutions
- PV of expected payouts eg grants made out of a foundation
Economic assets
financial assets + extended assets
Economic liabilities
financial liabilities + extended liabilities
Economic Net Worth
Economic Assets - Economic Liabilities
Lifecycle balanced funds
adjust asset allocations for individual investors over time by taking into account both financial assets and extended portfolio assets. As the individual ages, the equity/bond mix will increase its allocation to bonds as human capital decreases. at retirement, the target date fund may be invested in an asset mix that is closwer to 50% equity and 50% bonds
Approaches to asset allocation process
- asset only: maximizing returns and minimizing the risk and correlation of each asset class there. Liabilities are not modeled. Use MVO
- Liability relative: Manage the assets in relationship to meeting the liabilities. Consider the risk and return to the surplus (S = PVA - PVL)
- Goals-Based Investment: Manage sub-portfolios of assets to meet specific goals (quasi liabilities) eg children’s college fund
Lifestyle and aspirational objectives are part of which approach?
Goal based approach
Global Market Portfolio
Contains all available risky assets (ie global equity, global fixed income, real estate, etc.) in proportion to their total market values. It is also a portfolio that minimizes diversifiable risk since it is the most diversified portfolio possible.
Tactical Asset Allocation
active management strategy that deviates from the strategic asset allocation (SAA) to take advantage of perceived SHORT-TERM opportunities in the market. TAA introduces additional risk, seeking incremental return, often called alpha. These deviations from SAA weightings by asset class should be restricted by risk budgets or rebalancing ranges that control the amount of deviation.
Dynamic Asset Allocation
multiperiod investment horizon. Deviations from SAA in LONGER-TERM. DAA recognizes that asset (and liability) performance in one period affects the required rate of return and acceptable level of risk for subsequent periods. Changes to the SAA may be limited to simply adjusting the mix between stocks, bonds and cash. Conversely, global TAA may involve a broader and more complex multi-asset approach.
Challenges in using GMP
- establishing relative size of each asset class (non-publicly traded assets)
- practicality of investing in residential real estate
- liquidity and size challenges to investing in commercial real estate and private equity
- proxies (eg ETFs) to the GMP often use only traded assets
Risk Budgeting
Defining how much and where to take risk
Rebalancing
A disciplined process of restoring portfolio weights to the SAA
How do taxes impact rebalancing?
Taxes must be considered since realized capital gains and losses will impact investor taxes. Therefore, taxable portfolios will typically have wider rebalancing corridors than tax-exempt portfolios. The corridors may also be asymmetric due to tax savings (ie loss harvesting). This suggests that the range may be less below a certain target weight than above (eg the tolerance band may go from 48% to 55% for a 50% target weight)
How does volatility impact optimal corridor width?
Higher volatility (in the absence of high positive correlation between classes) will lead asset class weights to shift more quickly:
1. more frequent rebalancing increases transaction costs. This argues for wider corridors to control transaction costs, particularly when the costs are substantial.
2. higher volatility also argues for narrower corridors to control risk exposure
What do you mean by change in asset allocation constraints?
Change in constraints related to material changes in constraints, such as TIME HORIZON, liquidity needs, asset size, and regulatory or other external constraints.
