R13: Principles Of Asset Allocation

Question 1

What is MVO?

Answer 1

Process of finding the efficient portfolio (best possible SR) that maximises the utility.

Um=E(Rm)-0.005RaVariance

When Ra is the risk aversion.

If Us similar, use Roy’s safety first ratio (number of adverse standard deviation movements that must happen before the portfolio falls below a threshold return):
(E(Rm)-Rl)/standard deviation

Question 2

What are the criticisms of MVO?

Answer 2

• Weights are very sensitive to small changes in inputs
• Highly concentrated
• Only looks at mean and variance, not skewness or kurtosis
• Sources of risk may not be identified
• Only considers assets
• Single period, ignores trading costs, tax, CFs, serial correlation

Question 3

What are the three main liability-relative approaches?

Answer 3

Surplus optimisation: MVO with focus on surplus. Linear correlation, single time period.

Hedge/return seeking: hedge assets driven by same risk factors as liabilities. Only for over-funded, single time period.

Integrated approaches: A and L modelled together taking multi-period approach. Multi-time period.

Question 4

What are the advantages of a Monte Carlo simulation?

Answer 4

• Multi-period so can incorporate changing assumptions
• CFs
• Non-normal
• Periodic rebalancing and impact considered

Question 5

What’s the resampled efficient frontier?

Answer 5

Overcomes problem of being too sensitive to inputs. Uses Monte Carlo to generate thousands of potential efficient frontiers using different inputs and then take average.

Leads to a more diverse portfolio and weights are more stable over time.

Question 6

What’s reverse optimisation?

Answer 6

Overcomes problem of not being well-diversified by having the starting point being a globally diversified index.

Black Litterman backs out implied market returns using this and then tweaks them to reflect views and expectations. Then used in MVO to generate optimal portfolio.

Question 7

What are common characteristics to consider with liability-relative AA?

Answer 7

Contingent vs fixed CFs
Duration and convexity of liabilities
Timing uncertainty of CFs
Size of liabilities vs sponsor
Legal vs quasi 
Regulation

Question 8

Why does rebalancing increase returns and reduces risk?

Answer 8

Diversification return

Return from being short volatility

Question 9

What are some of the real-world constraints?

Answer 9

Asset class size 
Liquidity
Time horizon and impact on risk tolerance and AA
Regulatory constraints 
Tax