Reading 14: Asset Allocation w/ Real Word Constraints

Question 1

Taxable Portfolios

Answer 1

The effects of reduced returns in profitable periods and reduced losses in loss periods demonstrates that after-tax volatility is lower than pre-tax volatility. Lower after-tax volatility means that larger asset class movements are required to affect the risk profile of a portfolio so the rebalancing ranges can be wider. Assets subject to frequent trading should be allocated to tax-advantaged accounts.

Question 2

Tactical Asset Allocation Effectiveness

Answer 2

The risk-adjusted TAA portfolio’s effectiveness is best assessed by plotting its realized risk and return against the risk and return of the portfolios along the SAA portfolio’s efficient frontier. Even if the TAA portfolio had better Sharpe and information ratios than the SAA portfolio, it could still be less optimal than other portfolios along the SAA’s efficient frontier, Sharpe and info ratio can still be used. IPS limits cannot be breached in TAA. Success is dependant on market or factor timing not individual security selection.

Question 3

Contribution Risk: Pension Funds

Answer 3

The chance of having to increase contributions.

Question 4

Taxable & Deferred Tax Accounts

Answer 4

Assets subject to the highest rates of tax should be first allocated to tax advantaged accounts. Interest on high yield bonds is typically taxed at a higher rate than dividend income which in turn is taxed at a higher rate than capital gains.

Question 5

Tactical Asset Allocation

Answer 5

Discretionary TAA relies on qualitative interpretation of macroeconomic variables (GDP, inflation, yields, credit spreads, fundamentals). Systematic TAA takes a more quantitative approach using strategies that have been persistent and predictable (value and momentum approach). Tactical asset allocation attempts to take advantage of perceived inefficiencies in the relative prices of securities in different asset classes, and assumes that investor’s risk tolerance is unaffected by changes in wealth.

Question 6

Discretionary TAA

Answer 6

Market sentiment can be measured through: margin borrowing (good but if too high its bearish); short interest (increase drives down prices but too high can indicate markets at a low); volatility indices (bid-ask spread on index options).

Question 7

Taxable Accounts

Answer 7

The rebalancing range in the taxable account may be skewed to allow less deviation below (not above) the target weight to encourage realizing losses. Realizing losses can have tax benefits. Correlation data is a market-level issue and is not affected by the individual investor’s tax situation; thus, the same correlation matrix applies to both tax locations.