L3 Reading 3

Question 1

Proposed asset allocation is developed after

Answer 1

1. IPS is constructed
2. investment results are simulated over the appropriate time horizon
3. risk and return attributes of all possible asset allocation strategies are considered

Question 2

Decision reversal risk

Answer 2

Risk of reversing investment decisions at the worst possible time, creating maximum loss

Question 3

Capital Market Expectations

Answer 3

1. Expected return
2. standard deviation
3. correlation

Question 4

Client IPS Objectives and Constraints

Answer 4

RRTTLLU

1. risk
2. return
3. time horizon
4. tax considerations
5. legal
6. liquidity
7. Unique needs/ any other business

Question 5

Investment Governance Elements

Answer 5

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

Question 6

Extended portfolio assets

Answer 6

for individuals
- PV of expected earnings (human capital)
- PV of pension income

For institutions
- PV of royalties and exploitable resources

Question 7

Extended liabilities

Answer 7

For indviduals
- PV of expected future consumption

For institutions
- PV of expected payouts eg grants made out of a foundation

Question 8

Economic assets

Answer 8

financial assets + extended assets

Question 9

Economic liabilities

Answer 9

financial liabilities + extended liabilities

Question 10

Economic Net Worth

Answer 10

Economic Assets - Economic Liabilities

Question 11

Lifecycle balanced funds

Answer 11

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

Question 12

Approaches to asset allocation process

Answer 12

1. asset only: maximizing returns and minimizing the risk and correlation of each asset class there. Liabilities are not modeled. Use MVO
2. Liability relative: Manage the assets in relationship to meeting the liabilities. Consider the risk and return to the surplus (S = PVA - PVL)
3. Goals-Based Investment: Manage sub-portfolios of assets to meet specific goals (quasi liabilities) eg children’s college fund

Question 13

Lifestyle and aspirational objectives are part of which approach?

Answer 13

Goal based approach

Question 14

Global Market Portfolio

Answer 14

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.

Question 15

Tactical Asset Allocation

Answer 15

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.

Question 16

Dynamic Asset Allocation

Answer 16

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.

Question 17

Challenges in using GMP

Answer 17

• 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

Question 18

Risk Budgeting

Answer 18

Defining how much and where to take risk

Question 19

Rebalancing

Answer 19

A disciplined process of restoring portfolio weights to the SAA

Question 20

How do taxes impact rebalancing?

Answer 20

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)

Question 21

How does volatility impact optimal corridor width?

Answer 21

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

Question 22

What do you mean by change in asset allocation constraints?

Answer 22

Change in constraints related to material changes in constraints, such as TIME HORIZON, liquidity needs, asset size, and regulatory or other external constraints.