Portfolio Construction

Question 1

Traditional asset based allocation approach and the risk based asset allocation approach

Answer 1

• Asset based asset allocation
– Focuses on asset opportunities, usually based on risk/reward profiles as explained in MPT
– Asset allocation
– Focus on optimizing return given set level of risk
• Risk based asset allocation
– Focuses on risk metrics and risk factors when determining allocations
– Allocation based on risk factors and/or metrics
– Focus on risk outcomes, not performance

Question 2

Risk Budgeting

Answer 2

• Risk budgeting in portfolio management typically includes an asset allocation developed to meet specific risk criteria (e.g., appropriate or minimal levels of quantifiable risk).
• outcome focus is on risk levels, not performance.
• Risk is often, but not always measured by portfolio standard deviation and correlations between individual assets.
• Mean variance optimization can be used.
• Analysis of and implementation through risk factors (e.g., size, value, momentum, profitability, etc.) are often used.

Question 3

The Minimum Variance Portfolio

Answer 3

• The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least
• When correlation is less than +1, the portfolio standard deviation may be smaller than that of either of the individual component assets.

Question 4

Risk Parity investment strategies

Answer 4

portfolio approach to asset allocation that focuses on the amount of risk units allocated to each investment or asset class as opposed to percentage allocations to asset classes based on MPT and MVO 
-many risk parity portfolios leverage lower risk assets to achieve an acceptable expected return

Question 5

Optimal Portfolios and

Non Normal Returns

Answer 5

• Fat tailed distributions can result in extreme values of VaR (value at risk) and ES (expected shortfall) and encourage smaller allocations to the risky portfolio.
• If other portfolios provide sufficiently better VaR and ES values than the mean variance efficient portfolio, we may prefer these when faced with fat tailed distributions.

Question 6

Goal: Maximize compound growth

through risk return optimization

Answer 6

Remember that combining a low standard deviation with low correlation would help maximize compound growth. Low correlations can produce lower portfolio standard deviation. High variation or standard deviation may be attractive for any individual asset or security, but we typically seek lower standard deviation with low correlations in a portfolio, particularly when trying to optimize the portfolio’s risk return profile.