R18 Introduction to Asset Allocation

Question 1

R18

Life Cycle Balanced Fund

Answer 1

• A target date retirement fund (life cycle balance fund) incorporates human capital with asset allocation
• Human capital generally 30% equity, 70% Fixed Income

Question 2

R18

Asset Only

Answer 2

• Does not explicitly model liabilities or goals
• Example Mean Variance Optimisation - best to complement with Monte Carlo analysis.
• Maximize Sharpe ratio for acceptable level of volatility
• Liabilities or goals not defined and/or simplicity is important
• Relevant risk measure is the SD of portfolio returns - taking into account asset class volatilites and correlations

Some foundations, endowments

Sovereign wealth funds

Individual investors

Question 3

R18

Liability relative

Answer 3

• Models legal and quasi-liabilities
• Example Surplus Optimisation
• Fund liabilities and invest excess assets for growth
• Penalty for not meeting liabilities high
• Based on meeting liabilities - focus on institutions
• Relevant risk - not having enough asset in portfolio to cover liabilities. Measure SD of the surplus could be used as the relevant risk measure.

Banks

Defined benefit pensions

Insurers

Question 4

R18

Goals based

Answer 4

• Achieve goals with specified required probabilities of success
• Individual investors
• Each sub portfolio has unique asset allocation depending on goal
• Based on meeting liabilities - focus on individual
• Risk - not being able to achieve the stated goals. Probablity of meeting goals.

Question 5

R18

Asset Class Criteria (5)

Answer 5

1. Assets within an asset class should be relatively homogeneous. Assets within an asset class should have similar attributes. In the example just given, defining equities to include both real estate and common stock would result in a non-homogeneous asset class.
2. Asset classes should be mutually exclusive. Overlapping asset classes will reduce the effectiveness of strategic asset allocation in controlling risk and could introduce problems in developing asset class return expectations. For example, if one asset class for a US investor is domestic common equities, then world equities ex-US is more appropriate as another asset class rather than global equities, which include US equities.
3. Asset classes should be diversifying. For risk control purposes, an included asset class should not have extremely high expected correlations with other asset classes or with a linear combination of other asset classes. Otherwise, the included asset class will be effectively redundant in a portfolio because it will duplicate risk exposures already present. In general, a pairwise correlation above 0.95 is undesirable (given a sufficient number of observations to have confidence in the correlation estimate).
4. The asset classes as a group should make up a preponderance of world investable wealth. From the perspective of portfolio theory, selecting an asset allocation from a group of asset classes satisfying this criterion should tend to increase expected return for a given level of risk. Furthermore, the inclusion of more markets expands the opportunities for applying active investment strategies, assuming the decision to invest actively has been made. However, such factors as regulatory restrictions on investments and government-imposed limitations on investment by foreigners may limit the asset classes an investor can invest in.
5. Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio. Liquidity and transaction costs are both significant considerations. If liquidity and expected transaction costs for an investment of a size meaningful for an investor are unfavorable, an asset class may not be practically suitable for investment.

Question 6

R18

SAA (9 Steps)

Answer 6

1. Determine and quantify the investor’s objectives.
2. Determine the investor’s risk tolerance and how risk should be expressed and measured.
3. Determine the investment horizon(s).
4. Determine other constraints and the requirements they impose on asset allocation choices. What is the tax status of the investor? Should assets be managed with consideration given to ESG issues? Are there any legal and regulatory factors that need to be considered? Are any political sensitivities relevant? Are there any other constraints that the investor has imposed in the IPS and other communications?
5. Determine the approach to asset allocation that is most suitable for the investor.
6. Specify asset classes, and develop a set of capital market expectations for the specified asset classes.
7. Develop a range of potential asset allocation choices for consideration. These choices are often developed through optimization exercises.
8. Test the robustness of the potential choices. This testing often involves conducting simulations to evaluate potential results in relation to investment objectives and risk tolerance over appropriate planning horizon(s) for the different asset allocations developed in Step 7. The sensitivity of the outcomes to changes in capital market expectations is also tested.
9. Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed

Question 7

R18

Global Market Portfolio

Answer 7

• Global Market Portfolio is tangency portfolio
• The weights of the assets in the Global Market Portfolio can be adjusted up or down.
• Some assets can be difficult to invest in (e.g. residential real estate or private equity) so will use a proxy e.g. ETF’s

Question 8

R18

TAA

Answer 8

• Active managment choices for asset class weights
• Exploting short term opportunities
• However cost-benefit approach required - e.g. taxes, transaction costs.

Question 9

R18

Factors that influence asset owners’ decisions on where to invest on the passive/active spectrum

Answer 9

• Available investments.
• Scalability of active strategies being considered.
• The feasibility of investing passively while incorporating client-specific constraints.
• Beliefs concerning market informational efficiency. A strong belief in market efficiency for the asset class(es) under consideration would orient the investor away from active management.
• The trade-off of expected incremental benefits relative to incremental costs and risks of active choices. Costs of active management include investment management costs, trading costs, and turnover-induced taxes; such costs would have to be judged relative to the lower costs of index alternatives, which vary by asset class.
• Tax status. Holding other variables constant, taxable investors would tend to have higher hurdles to profitable active management than tax-exempt investors.

Question 10

R18

Rebalancing

Answer 10

• Higher transaction costs for an asset class imply wider rebalancing ranges.
• More risk-averse investors will have tighter rebalancing ranges.
• Less correlated assets also have tighter rebalancing ranges.
• Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion encourages tighter ranges.
• Illiquid investments complicate rebalancing.
• Derivatives create the possibility of synthetic rebalancing.
• Taxes, which are a cost, discourage rebalancing and encourage asymmetric and wider rebalancing ranges.