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CFA Level 3 > Revised Asset Allocation > Flashcards

Revised Asset Allocation Flashcards

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1
Q

What is investment governance?

A

This is the structure that is expected to ensure that assets are invested to achieve asset owners investment objectives within risk tolerances and constrains

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2
Q

Draw the framework that connects the IPS, capital market expectations, and the SAA

A

Draw

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3
Q

What are the three levels of investment governance structure?

A
  1. Governing investment committee
  2. Investment Staff
    3) Third party resources
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4
Q

What are the 6 common traits that make an investment governance model effective?

A
  1. Articulate long and short-term objectives (returns, liabilities, liquidity, etc)
  2. Allocate decision rights and responsibilities among functional units - who does what? why?
  3. Specify the process for developing and approving the IPS
  4. Specify the process for development and approval of SAA - typically the investment committee
  5. Establish a reporting framework - where are we now relative to goals? What value has been added?
  6. Periodically audit - independent 3rd party
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5
Q

What are the different elements of the IPS

A
  1. Purpose
  2. Objectives
  3. Duties
  4. Guidelines
  5. Reporting
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6
Q

What are the extended assets and liabilities listed on an economic balance sheet?

A
  1. Human capital (PV of earnings)
  2. PV of pension income
  3. PV of expected inheritance
  4. PV of future consumption
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7
Q

What are the investment objectives of asset only, asset-liabilities, and goal based mandates?

A

Asset based typically MVO on the assets, does not consider liabilities. This goal is to maximize sharpe ratios.
Asset liabilities are typically using mean variance optimization including the correlation and values of liailities. The goal is to fund liabilities, MVO for excess
Goal based involves sub portfolios each with risk, time horizon, and other constraints. The goal is to maximize the probability of success for each goal.

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8
Q

What are the relevant risk measures for asset based, asset-liabilitie based, and goal based strategies?

A

Asset - variance, downside risk (VaR, Sortino), monte carlo
A-L - risk of shortfall, volatility of cont
Goal based - overall risk of not achieving, overall portfolio risk

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9
Q

What are the three super asset classes?

A
  1. Capital assets (source of value)
  2. Consumable or transformable - commodities
  3. Store of value - currency, art, gold
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10
Q

What are the three criteria for specifying asset classes?

A
  1. homogenous within class
  2. Mutually exclusive
  3. Diversifying
  4. Must be large, global, and widely investable
  5. Capacity to absorb meaningful part of portfolio
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11
Q

What are the risk factors that can describe equity investing? Fixed Income?

A
  1. GDP growth
  2. Volatility
  3. Currency
  4. Value
  5. Liquidity
  6. Momentum
  7. Size
  8. Inflation
Fixed Income
1. Inflation*
2. Capital structure
3. Volatility*
4. Currency*
5. Real rates
6. Convexity
7. Default risk
8. Duration
9. Liquidity*
More overlap means more correlation
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12
Q

What are the steps to selecting an asset allocation?

A
  1. Quantify objectives
  2. Establish risk tolerance
  3. Determine time horizon
  4. Determine other constraints
  5. Determine asset allocation approach
  6. Specify asset classes and expectations
  7. Develop range of choices for consideration
  8. Test
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13
Q

Why are risk factor models more relevant for liability driven mandates?

A

They have funding goals and hold more fixed income

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14
Q

What is the difference between tactical and dynamic asset allocation?

A

tactical is short term, dynamic is longer term

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15
Q

What are the strategic considerations for rebalancing strategies?

A
  1. Transaction costs for different asset classes
  2. Risk aversion makes for tighter rebalancing ranges
  3. Less correlated assets will have tighter ranges
  4. Do you believe in momentum?
  5. Illiquidity
  6. Derivative use
  7. Taxes - more likely to rebalance on the downside
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16
Q

What is the objective function for MVO?

A 
Max utility U = E(r) - 0.005*lamda*Var
Find the asset class with the highest utility
Higher lamda will result in more conservative portfolios
Lamba = 0 means you are risk neutral
Lamba = 4 means moderately risk averse
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17
Q

What is the global minimum variance portfolio?

A

This is the portfolio that has the highest slope on the efficient frontier

18
Q

What is the safety first criteria and what does it measure?

A 
SF = E(r) - Lowest Required Return/SD
This measures (subject to z scores) the probability of hitting a goal
19
Q

What are the criticisms of MVO?

A
  1. Very sensitive to changes in inputs
  2. Concentration - could use reverse optimization or constraints
  3. Investors care about more than mean and variance
  4. Sources of risks may not actually be diversified (use factor instead)
  5. Does not concern itself with liabilities
  6. Single period framework
20
Q

What is reverse optimization?

A

This is similar to MVO but instead you solve for returns rather than weights. You would take starting weights, calculate Beta’s, use covariances with each other and find what the market is implying returns of each asset class would be.

21
Q

What is the black-litterman model?

A

This is a modified method of reverse optimization. You can specify the differences you see vs the return results generated by the reverse optimization and then use MVO to see how you should adjust weights.

22
Q

What is resampled MVO?

A

This is a monte carlo method where you actually simulate the efficient frontier and then average the results

23
Q

How can we include less liquid assets in the MVO process?

A
  1. Optimize one section and reserve the other section for the illiquid asset
  2. Include but attempt to model returns (factor based)
  3. Include and use publically traded data to estimate returns (violates asset class exclusivity)
24
Q

What is the marginal contribution to total risk?

A

This is the marginal change in risk for a small chance in asset class weighting. This is the Beta (sensitivity of asset class to return in the portfolio) * Portfolio SD desired at that level

25
Q

What is the absolute contribution to total risk?

A

This is the actual contribution to risk. This is the weighting * marginal contribution to risk. Summed these will equal total volatility of the portfolio

26
Q

Based on the absolute contribution of marginal risk, how do you optimize asset class weightings?

A

You know that this is optimized when the Expected return of the asset - risk free weight/Marginal contribution to risk is equal across all assets. Summed, these will equal the sharpe ratio.

27
Q

What is the objective of risk budgeting in general?

A

The purpose is to efficiently allocation risk. For a given level of risk, you would want to construct a portfolio that achieves the maximum return.

28
Q

What are the different characteristics of liabilities?

A
  1. Fixed vs contingent
  2. Legal vs Quasi
  3. Duration and convexity
  4. Value of liabilities compared to size of org (under vs over funded)
  5. Factors driving value of future liability
  6. Timing considerations
  7. Regulations
29
Q

What is the basic premise of surplus optimization?

A

This is an extension of MVO where you take all assets over liabilities and optimize.

30
Q

What is the utility function for asset liability portfolios and how does it differ from traditional utility curves?

A

The utility function is normal, however expected return is measured as the expected return on surplus (Change is surplus or deficit)/MV assets beg. period.

31
Q

What would we expect the difference in optimized portfolios to be between asset based vs A/L based for a low level of risk?

A

They would be much different, as the A/L will be overweight any hedging assets. Higher risks will look very similar

32
Q

What is the basic premise of a hedging/return seeking portfolio? What are the two types?

A

This is a two portfolio approach where you create one hedging portfolio and the rest you will invest in a return seeking portfolio.
1. Type one is the basic which you would use if you have a surplus, are very conservative, or have a liability that could wipe out the firm. you would fully hedge the liabilities and and only invest excess
2. type 2 is the variant where you only partially hedge the liabilities. You would use this if you are not conservative, have a current deficit, or have a massive firm that can take on more risk
You can make this dynamic if you choose

33
Q

What is the basic premise of an integrated A/L approach?

A

This is typically used by banks, insurance companies, where the level of liability is directly affected by the type of assets.

34
Q

How does being a small firm affect your investment opportunities?

A
  1. You may not meet minimum investment requirements

2. You may not have governance capacity or enough knowledge

35
Q

How does being a big firm affect investment opportunities?

A
  1. your desired minimum investment may be too big for managers to handle
36
Q

How do liquidity constraints in the real world affect asset allocation decisions?

A
  1. The liquidity needs of asset owners will vary by goals, time horizon, and regulatory factors
  2. The liquidity characteristics of assets may not align with your goals
37
Q

How does time horizon in the real world affect asset allocation decisions?

A
  1. Changing human capital

2. Changing character of liabilities

38
Q

What should cause you to revisit the SAA?

A
  1. Changes in goals
  2. Changes in constraints (time horizon, liquidity, etc)
  3. Changes in beliefs
39
Q

What are the two approaches to TAA?

A
  1. Discretionary

2. Systematic

40
Q

What are the behavioural biases you need to deal with in AA?

A
  1. Loss aversion - scared to stick to SAA during hard times
  2. Illusion of control - excessive trading, leverage
  3. Mental accounting - goals based will actually incorporate
  4. Representative bias - return chasing
  5. Framing bias - how do you present risk to a client?
  6. Availability bias - home bias

CFA Level 3 (28 decks)

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