Portfolio Construction

Question 1

What is long-term strategic asset allocation

Answer 1

relatively static asset allocation - that will not be changed over the long term

It is a neutral position intented to meet client’s objectives over the long term

Starting point of the portfolio construction process

Question 2

What is Tactical Asset Allocation

Answer 2

Chasing alpha by under/overweighting asset classes

when contrasted to their long term weights

Question 3

Give an example of TAA

Answer 3

Manager expects equity to underperform

Underweight equity by 10%, overweight bonds and cash by 5% each.

Question 4

What is CPPI?

Answer 4

Constant Proportion Portfolio Insurance

Question 5

What are the three figures used to calculate CPPI?

Answer 5

1) Floor = Amount that must be protected
2) Cushion = Difference between portfolio value and floor
3) Multiplier = 1 / max drawdown %

Question 6

Pros of CPPI?

Answer 6

1) Useful when a lump-sum (e.g. house deposit) must be protected
2) Does not forego capital gains by only investing in safe assets
3) No leverage = less risk

Question 7

Cons of CPPI?

Answer 7

1) Stop-loss mechanic takes away potential upside
2) Cushion will be rebuilt slowly after max loss
3) May not capatalise on a market rally after a large fall
4) CPPI will fail if max loss is exceeded
5) Needs regular rebalancing

Question 8

Pros of SAA

Answer 8

1) Appropriate for a long term investor happy to tolerate risk
2) Sees past short term volatility
3) Inexpensive in terms of trading costs
4) Does not require intensive management

Question 9

What are some pros of Asset liability approaches?

Answer 9

1) You do not endanger the capital that needs to be protected
2) Leverage can take small capital and generate large returns
3) No rebalancing = low cost and simple

Question 10

What are some cons of asset liability approaches?

Answer 10

1) VaR figure has to be accurate
2) If interest rates are too high cannot be done
3) Need to have a broker for leverage

Question 11

What are some pros of core satellite portfolios?

Answer 11

1) Cost efficient
2) Focus on areas where value can be added
3) Lower volatility than fully active
4) More customisation

Question 12

What are some cons of core satellite portfolios?

Answer 12

1) Increased management (rebalance / research)
2) Additional risk (management, active share etc)
3) Potential for no different result (lags or matches index)

Question 13

Merits of Risk Parity Allocation

Answer 13

1) Improved Risk-Adjusted Returns
2) Leverage can improve returns
3) Leverage counter balances weight to safe asset
4) Enhanced Diversfication

Question 14

Cons of Risk Parity Allocation?

Answer 14

1) Leverage can be too high (during high interests)
2) Client may not be able to borrow enough
3) More complex to maintain / rebalance the desired balance.

Question 15

What does can an ESG screen introduce to a portfolio?

Answer 15

Sector Bias
(screens are not sector neutral)

Question 16

How to implement a sector neutral screen?

Answer 16

Best in sector positive screen

Question 17

What risks do money market funds pose vs T-Bills

Answer 17

1) Foreign Currency exposure
2) Invest in companies - can default (FIGs / CORPs)
3) Interest introduces reinvestment risk
4) Counterparty risk from 3rd party fund provider

Question 18

What real world factors prevent someone from holding the efficient portfolio?

Answer 18

1) Round lot sizes
2) Liquidity / Availability (e.g. foreign controls)
3) Risk management
4) Ethics, Regulation

Question 19

What flexibilities are given by boards to fund managers to make TAA tilts?

Answer 19

1) Risk Budget
2) Tramlines for Asset Classes
3) Tracking Error
4) Seperate Sleeves
5) bps allocation based on conviction

e.g. 100bps conviction, 200bps strong conviction

Question 20

What is portfolio dedication?

Answer 20

Structuring a portfolio so that it meets a series of future liabilities.

e.g. zero coupon bonds expiring on liability date
use of fixed income etc.

Question 21

Give benefits of Smart/Alternative beta indices

Answer 21

1) Underweight large stocks = diversification
2) Not procyclical = better in downturn
3) Can follow a long run factor (e.g. low P/E, momentum etc)

Question 22

Give cons of Smart/Alternative Beta indices

Answer 22

1) Higher cost
2) Higher risk (active risk)
3) If the factor becomes popular it will dissapear