Overview of Asset Allocation Flashcards
What is investment governance?
What do they do?
- Investment governance represents the organization of decision-making responsibilities and oversight activities.
A common governance structure in an institutional investor context will have three levels within the governance hierarchy:
1) Governing investment committee (board of directors / staff)
2) investment staff (large in-house or small overseeing external)
3) 3rd party resources (consultants, custodians)
Effective gov will do this:
1 Articulate the long- and short-term objectives of the investment program (usually return req, risk tolerance)
2 Allocate decision rights and responsibilities among the functional units in the governance hierarchy effectively, taking account of their knowledge, capacity, time, and position in the governance hierarchy. (committee delegate, approve, the staff research, draft, assess, propose and 3rd party provide inputs)
3 Specify processes for developing and approving the investment policy statement that will govern the day-to-day operations of the investment program. (revised slower than AA)
4 Specify processes for developing and approving the program’s strategic asset allocation. (formal asset allocation study accounting for objectives is proposed, with simulations, with R&R evaluated and proposed to committee)
5 Establish a reporting framework to monitor the program’s progress toward the agreed-on goals and objectives. (where are we now, where are we relative to goals, what value has been added by mgmt? Benchmarking for perf measurement, mgmt reporting - asset perf and governance reporting - programme execution)
6 Periodically undertake a governance audit. (avoid decision reversal risk, ensure accountability, survivability, ID biggest risks, check staff)
There are allocation methods that focus on assigning investments to the investor’s desired exposures to specified risk factors. Sometimes asset classes have overlaps in source of risk: US Equity and US Corporate bonds are both sensitive to say inflation, volatility, liquidity but also have distinct factors (equity has value, size, momentum and bonds have default risk, convexity). So instead of asset classes look at risk factors.
Explain how to do this approach to AA:
- Specify risk factors and desired exposure to them
- They can be described in terms of sensitivity
- Not directly investable. Construct asset classes that isolate that risk.
- Go short or long
- Using multifactor risk models in AA is ‘factor based AA” NOT Asset classbased AA
Although risk factors can be thought of as the basic building blocks of investments, most are not directly investable. In this context, risk factors are associated with expected return premiums.
Long, short, derivatives, explain how to achieve these risk factor exposures:
- Inflation
- Real IR
- US volatility
-Credit Spread - Duration
- Inflation: Going long nominal Treasuries and short inflation-linked bonds isolates the inflation component.
- Real IR: Inflation-linked bonds provide a proxy for real interest rates.
- US volatility: VIX (Chicago Board Options Exchange Volatility Index) futures provide a proxy for implied volatility.
-Credit Spread: Going long high-quality credit and short Treasuries/government bonds isolates credit exposure.
- Duration: Going long 10+ year Treasuries and short 1–3 year Treasuries isolates the duration exposure being targeted.
Why use Factor Models?
The desire to shape the asset allocation based on goals and objectives that cannot be expressed by asset classes (such as matching liability characteristics in a liability-relative approach).
An intense focus on portfolio risk in all of its various dimensions, helped along by availability of commercial factor-based risk measurement and management tools.
The acknowledgment that many highly correlated so-called asset classes are better defined as parts of the same high-level asset class. For example, domestic and foreign equity may be better seen as sub-classes of global public equity.
The realization that equity risk can be the dominant risk exposure even in a seemingly well-diversified portfolio.
What should traditional asset classes be
Assets within an asset class should be relatively homogeneous;
asset classes should be mutually exclusive; (Don’t do US Domestic then Global Equities, use World ex-US to avoid double up)
asset classes should be diversifying; (pairwise correlation <0.95 otherwise duplicating risk).
asset classes as a group should make up a preponderance of the world’s investable wealth; (regulations amy get int he way, big universe allows active mgmt)
asset classes selected for investment should have the capacity to
absorb a meaningful proportion of an investor’s portfolio (if we cant get liquidity and transaction costs controlled we may not use the asset class).
Asset-Only Allocation:
What is it? What does it use? How does it work?
- based on the principle of selecting portfolios that make efficient use of asset risk. The focus here is mean–variance optimization.
- Given a set of asset classes and assumptions concerning their expected returns, volatilities, and correlations, this approach traces out an efficient frontier that consists of portfolios that are expected to offer the greatest return at each level of portfolio return volatility.
- The Sharpe ratio is a key descriptor of an asset allocation: If a portfolio is efficient, it has the highest Sharpe ratio among portfolios with the same volatility of return.
- Sharpe by itself cant confirm absolute portfolio risk is within our range. Also, VAR and funded ration are important measures.
- Investor might quantify risk tolerance in mean-variance terms as “I will tolerate 17% volatility per year”
What is the global market portfolio? Issues?
- A baseline allocation to begin with. It is the global portfolio with no diversifiable risk and useful starting point to avoid home country bias.
- Assets allocated in propertion to global portfolio of stocks, bonds, real assets. Then a second layer - Disaggregate this broad asset classes into region, country and secuirty by capitalisation. Accept them or alter them.
- The issue is estimating the size given there are non publicly traded assets. Much of private RE is individual so thats questionable. Commercial RE and PE are not easily carved up. Often we use proxies instead ie ETFs. Sometimes people alter the weighting scheme; usng GDP or equal weight.
Liability Relative AA:
What is it?
How does it differ to AO allocation (65/35) where you have pension liabilities of $1.087 Billion and $1.5B in Assets?
Choosing an AA in relation to the objective of funding liabilities.
- You can do MVO to the surplus (A - L)
- You can do liability-hedging portfolio focussed on the liabilities, and for any balance, a risky-asset or ‘return-seeking portfolio’.
- A liability relative approach will put 1.125B in FI that matches IR sensitivity to the PV of plan liabilities. This is the liability hedgind portfolio. Then 0.125B goes toward return seeking equities. This is to help the buffer without losing funding status. If stat goes <1, we have to contribute. Beware sometimes the portfolio with the lowest PV of contributions might be the riskiest.
- Using the AO portfolio, its 0.65 x 1.25 = 0.8125B in equities. The buffer is 1.25 - 1.087 = 0.163. Therefore if equities fall 20% the plan is underfunded. Whereas the liability portfolio, it has FI that is matched in risk and has little contribution risk.
Explain a liability glide path for an underfunded Pension Plan:
As the funded status and contributions are made, we have already specified the desired portion of liability hedging assets and return seeking assets and the duration of the liability hedge.
The optimal asset allocation is sensitive to changes in the status of the plan.
The objective is to increase the funded status by reducing surplus risk over time.
Goals based investing: What does it overcome and how does it work?
It overcomes people ignoring money’s fungibility and assigning specific dollars to specific uses (mental accounting).
This approach uses the mental accounting and helps people embrace more optimal portfolios with higher risk than they normally would It assigns higher risk to long term aspirational objectives and conservative allocation for sub portfolios involving lifestyle preservation.
The adviser will ascertain the goal’s importance and caibrate the requirred probabilities of achieving the goals ie 99%. Sub portfolios are made bottom-up and have different horizons and risk, unlike the pension fund AA. The higher the probability, the higher the assets needed now. The DR is set lower and we discount the amounts back to the present. The risk is the risk of not achieving the goals.
What are two dimensions of passive/active implementation?
What to consdier when looking at the spectrum?
- First dimennsion is TAA. Short term tilts away from the SAA. Often a mandate specifies rules to keep it in risk budget or rebalance range. Could be response to price momentum, valuation or business cycle. Must consider monitoring and trading costs. Is it worth it?
- Other dimension is decisions about how capital and active risk is allocated to points on the passive active spectrum. For passive they just follow the index composition (market cap weighted) or hold bonds till maturity. They don’t care if CME change. An active manager will change to info or CME changes.
You could also choose a Value style index. You now have passive implementation as it involves indexing. But it has an active tilt away from the global market portfolio. Or a GDP weighted global bond index - the weighting scheme is an active choice but the global bonds are passive.
To consider when looking at where to invest: is there an investable index to begin with? How’s the scale, is there a min size or are we too big? Does the client have ESG concerns? Do we think an asset class has EMH anyway? What’s the trade off for costs anyway? How about tax status - dont want to churn. We need the resources to manage the allocation too.
Risk budgeting is a tool that may be useful in a variety of contexts and asset allocation approaches. Can be stated absolute or relative and $/%. Can be quantified as variance or SD for volatility or for tail risk it could be VaR or drawdown. For ex my overall risk budget is an absolute volatility of 20%.
So we define risk in some measure, then how do we approach AA with this focus on risk?
- We look at distributing risk without regard for returns, across the assets. A type of this is risk parity whereby each asset class contributes an equal amount of risk.
- Regarding active/passive we can use active risk budgets. How much benchmark relative risk can we take to outperform? The benchmark is our risk measure, we could use it as the SAA benchmark or we could look at the asset class benchmark.
What are the types of rebalancing?
What makes wider rebalance ranges?
- Calendar rebalancing: monthly etc and this is arbitrary.
- Percentage range: So target is 50% and the triggers are 45 and 55 so the rebalance range is 10%. From here we look at how often we (can afford) check, and when we trigger, do we go back to target, the edge or half way?
use wider rebalance ranges:
- Higher transaction costs
- Less risk averse investors
- Higher correlated assets (they move together anyway)
-Belief in momentum (not mean reversion)
- Taxes / costs (int)
- illiquid
