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CFA L3 Matheus > Section 2 - R5/R6/R7 - Asset Allocation > Flashcards

Section 2 - R5/R6/R7 - Asset Allocation Flashcards

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1
Q

Governance Structure of Asset Allocation (List of #3)

A

1) Governing Investment Committee
2) Investment Staff
3) Third Party Resources

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2
Q

6 Elements of Effective Governance

A

1) Articulate ST and LT objectives

2) Allocate decision rights and responsibilities to the right hierarchy levels

3) Specify the process to develop/approve IPS

4) Specify the process to develop/approve SAA

5) Establish a framework to monitor progress towards investor’s goals

6) Undertake governance audit

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3
Q

Economic Balance Sheet (Structure)

A

1) Conventional Assets and Liabilities
2) PV Pension Income + PV Inheritance + PV Future Consumption

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4
Q

Investment Approaches (3 list)

A

1) Asset Only: Enchance Mean-Variance Optimization

2) Liability-Relative: Bank-like

3) Goals-Based: Mainly for individuals and families

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5
Q

Relative Risk Concepts (per investment approach)

A

1) Asset-Only: Vol / Tracking Error / VaR / Monte-Carlo

2) Liability-Relative: Shortfall Risk

3) Goals-based: Risk of Failing to Achieve Goals

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6
Q

Asset Classes (Greer Classification)

A

a) Capital Assets: ongoing source of value
b) Consumable / Transformable Assets: commodities
c) Store of Value Assets: currencies, gold, art

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7
Q

Criteria for Specifying Asset Classes (List)

A

1) Assets within a class should be homogenous

2) Asset classes should be mutually exclusive

3) Asset classes should be diversifying (low correl)

4) Sum up to a good part of investable wealth

5) Should have capacity to absorb a meaningful proportion of an investor’s portfolio

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8
Q

Factor Based Investment Approach (Concept)

A

Factor-Based Approach: Do not use asset class as the basis for portfolio construction

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9
Q

Strategic Asset Allocation (SAA Steps)

A

1) Quantify objectives
2) Establish risk tolerance
3) Determine Investment Horizon
4) Determine other constraints and requirements
5) Determine suitable asset allocation

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10
Q

Investment Approaches: Asset-Only (Details)

A
  • Portfolios that make efficient use of asset risk
  • Sharpe-ratio is a key metric
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11
Q

Investment Approaches: Liability-Relative (Details)

A
  • FI is more relevant
  • If underfunded: equities would have a higher weighting
  • Risk-Factor approaches are more relevant (interest rate sensitivity, inflation, credit risk)
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12
Q

Investment Approaches: Goals-Based (Details)

A
  • SAA works in a bottom-up fashion.
  • Personal, Dynastic, Philantropic.
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13
Q

Global Market Portfolio (Concept)

A
  • GMP sums up all the investable assets held by investors. Reflects supply and demand of global investors.
  • Minimizes non-diversifiable risk and therefore makes the most efficient use of the risk budget.
  • Provides discipline in mitigating home country bias.
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14
Q

Implementation Choices (Criteria List)

A

Passive / Active Choices:

  1. Asset Weights (Tactical, Dynamic)
  2. Allocation to Asset Classes (Passive, Active)
  3. Range: Passive Indexed, Non-Cap Weight, Traditional Active Strategy, Aggressive Active (Unconstrained)
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15
Q

Rebalancing Options (List)

A
  • Calendar Rebalancing: Periodic Basis
  • Percent Rebalancing: % of Value around target values acting as triggers
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16
Q

Rebalancing Trade-Off Considerations (List)

A

List:

1) ↑ Transaction Costs = ↑ Ranges

2) ↑ Risk Averse = ↓ Range

3) Belief in Mean Reversion = ↓ Range

4) Belief in Momentum = ↑ Range

5) ↓ Less Correlated Assets = ↓ Range

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17
Q

Mean-Variance Optimization (Formula and Constraints)

A

U(m) = E(R) - 0.005λσ², onde

U = Utility
E(R) = Expected Return
λ = Aversion Coeff (0 = neutral / 4 = risk averse)
σ² = Variance

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18
Q

MVO Constraints (List)

A
  • Single-period framework
  • Capital Market Expectations should be matched with time horizon
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19
Q

Minimum Variance Portfolio (Concept)

A
  • Highest cash possible
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20
Q

Example of Modelation to MVO

A

Ex.: 45 yr old professor

a) 55% GBP 1.5kk (Financial Assets)

b) 20% GBP 0.5kk (PV Future Earnings):

Model as (i) 70% Long Dur Inflation Bonds, (ii) 15% UK Corporate Bonds, (iii) 15% UK Equities

c) 30% UK Real Estate: Model as Property Index in London

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21
Q

Monte Carlo Simulation (List of Benefits)

A

Benefits: (i) Model Potential Outcomes (ii) Likelihood of meeting various goals at the same time (iii) Outputs very sensitive to small changes

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22
Q

Monte Carlo Simulation (Criticism and Solutions)

A

Criticisms: (i) Concentrated Allocations (ii) Outputs very sensitive to inputs.

For both, use:

Reverse Optimization. Forma de ancorar a diversificação.

a. MVO = E(R) -> % Peso

b. Reverse MVO = Parte do % Peso de Mercado como Ótimo + Cov + Risk Aversion -> Find E(R)

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23
Q

Tactical Asset Allocation (Concept)

A

Concept: Short term tilts. Should keep deviations from SAA within ranges or risk budgets. Performed @ asset class level and is asset-only approach.

Types: Discretionary / Systematic (technical analysis and market signals)

Measurement of Success: Sharpe, Info Ratio, Plot Realized Return v. SAA

24
Q

Dynamic Asset Allocation (Concept)

A
  • Incorporates deviations from SAA motivated by LT valuation signals
25
Q

Mean Reverse Optimization (MVO)

A

Reverse MVO = Parte do % Peso de Mercado como Ótimo + Cov + Risk Aversion -> Find E(R)

a. Assume Optimal Weights + Cov + λ
b. Solve for Expected Returns (R)
c. Observe market weights
d. Calculate β for market weight
e. Calculate E(Ri) = Rf + β(Mkt Risk Premium)

26
Q

Black-Litterman Model (Concept, Pros and Cons)

A

Model allows investor to add its own distinctive views from the produced by Reverse MVO.

Ex.: Specify (a) allocation to specific asset; (b) allocation range for an asset.

Steps: MKT Portfolio -> E(R) + Risk Premiums + Cov -> % Weights -> Force weights.

Pros: Good diversification, overcomes weakness of MV which is the variability of estimated returns.

Cons: Static approach, difficult to estimate returns.

27
Q

Factors affecting choice between Passive and Active

A
  • Available Investments
  • Scalability of Active Strategies
  • Feasibility of Passive Investing
  • Belief in efficiency of the market (are prices correct?)
  • Trade-Offs
  • Tax Status
28
Q

Resampled MVO (Concept, Pros and Cons)

A
  1. Perform MVO
  2. Use Monte Carlo Simulation to estimate a # of market assumptions (change it by small variations)
  3. Generate many efficient frontiers for each set of inputs
  4. Average Results

Pros: More MVO outputs result in better diversification and a more stable efficient frontier.

Cons: No mathematical rationale behind the method. Idea is to bootstrap.

29
Q

Reverse MVO (Criticism -> Solution)

A
  1. Low diversification -> Use Factors
  2. No link to liabilities -> Use Liability-Relative Allocation
  3. MVO is single-period -> Use Simulation
  4. Hard to include less liquid assets because their market inputs are less accurate -> Exclude them from MVO and give them a specific allocation OR include but treat them with a specific model
30
Q

Risk Budgeting (Description of Process)

A
  1. Identify Total Desirable Risk (σ)
  2. Allocate risk among asset classes
31
Q

Marginal Contribution Total Risk
(MCTR Formula and Concept)

A

MCTR = (βi asset class * σ portfolio)

Concept: Impact of an Additional Market Risk from a specific asset class to the total portfolio variance.

Pros:
- You can identify marginal contributions to portfolio risk
- You can determine optimal marginal gains
- Allows you to create risk budgets

32
Q

Absolute Contribution to Risk
(Formula and Concept)

A

ACTR = Wi * MCTR

σ portfolio = Σ ACTR all assets

33
Q

Optimal Asset Allocation (Formula and Concept)

A

Formula: (E (Ri) - Rf ) / MTCR same for all

An asset allocation is optimal when (Excess Return - Rf) ÷ MCTR is the same for all asset classes.

If MTCRa > MCTRb, logo Excess Return B > Excess Return A. Logo, aumente peso de B

34
Q

Factor Based Allocation (List)

A
  • Market
  • Size
  • Valuation
  • Momentum
  • Liquidity
  • Duration
  • Credit
  • Volatility
35
Q

Liability Attributes (List)

A
  1. Fixed / Contingent
  2. Legal / Quasi-Liabilities
  3. Duration / Convexity
  4. Value of Liability
  5. Factors influencing: economic, inflation, interest rates, premiums
  6. Timing
  7. Regulations
36
Q

Surplus Optimization (Concept)

A
  1. Concept: Approach to asset allocation
  2. Find Surplus = (MVasset - PV Liabilities)
  3. Allocate surplus to MVO
  4. MVO Formula: U(m) = E(R) - 0.005λσ²
37
Q

Hedge Return Seeking Portfolio (Concept)

A

Divides in 2 sub-sets:

(1) Hedging Portfolio
(2) Return Seeking
or

(1) Partial Hedged
(2) Return Seeking

38
Q

Integrated ALM Approach (Concept)

A

Decisions regarding assets and liabilities are integrated. Banks and insurance companies follow this approach.

39
Q

Goals-Based Asset Allocation (Concept)

A

Given:
Client Goals are 1, 2 and 3
Modules are A, B, C, D and E

For each client goal, a subportfolio will be created to fund the individual goal. It will have its own Time Horizon and Required Probability of Success

40
Q

Heuristic Asset Allocation (Definition)

A

Unlike more sophisticated approaches such as traditional MVO, they are not based on theoretical models and don’t require sophisticated mathematics

41
Q

Heuristic Asset Allocation Approaches (List)

A
  1. Equity Allocation = (120 - Age)
  2. 60% Stocks / 40% Bonds
  3. Endowment Model (Yale): Emphasize allocation to non-traditional investments
  4. Risk Parity: wi * Cov(ri*rp) = (1/n) * σ² portfolio
  5. Weight = (1/n)
42
Q

Rebalancing Diversification Return (Concept)

A

↑ Risky Assets = ↑ Compound Returns = ↑ Concentration of Portfolio

[(1+Rp)^n] > w1(1+r1)^n + w2(1+r2)^n + w3(1+r3)^n

Formula Meaning: Retorno sobre retorno do portfolio > Retorno Médio de cada ativo pesado porque é mais arriscado e concentrado

43
Q

Asset Allocation Constraints (List)

A

a. Size
b. Liquidity
c. Time Horizon
d. Regulatory Constraints
e. Taxes

44
Q

After-Tax Portfolio Optimization (Concept)

A
  • Adjust each asset class E(Ri) and σi for expected tax
  • It requires an adjustment to the asset’s current market value
45
Q

Rebalancing Strategies (List)

A
  1. Tax-Loss Harvesting: Strategy to sell underperforming assets from your portfolio to avoid early payment of taxes
  2. Tax Location: Place less tax efficient assets in accounts with favorable tax treatment
46
Q

SAA Revision Criteria (List)

A
  1. Goals: Change in business conditions or personal circumstances affecting expected cashflows
  2. Constraints: Time Horizon, Liquidity, Asset Size, Legal/Regulatory
  3. Beliefs: Changes in the CME (Capital Mkt Expectations)
47
Q

Behavioral Biases (List)

A
  1. Loss Aversion
  2. Illusion of Control
  3. Mental Accounting
  4. Representative Bias
  5. Framing Bias
  6. Availability Bias
48
Q

Bahavioral Biases Mitigation (List)

A
  1. Loss Aversion: GBI
  2. Illusion of Control: GMP as start point
  3. Mental Accounting: GBI incorporates
  4. Representative Bias: Strong SAA + Governance
  5. Framing Bias: Present in different ways
  6. Availability Bias: GMP as start point
49
Q

Loss Aversion Bias (Description)

A

People assign a greater weight to
potential negative outcomes than positive ones. As a result, they strongly prefer avoiding losses.

Mitigation: Goals-based investing by framing risk in terms of shortfall probability or by funding high-priority goals with low-risk assets

50
Q

Illusion of Control Bias (Description)

A

People tend to believe that they can control or influence outcomes when, in fact, they cannot. Illusion of control bias has been defined as the “expectancy of a personal success probability inappropriately higher than the objective probability would warrant.”

Consequences: Frequent trades, alpha-seeking, excessive

51
Q

Hindsight Bias (Description)

A

Hindsight bias is a bias with selective perception and retention aspects. People may see past events as having been predictable and reasonable to expect.

Consequences: Overconfidence

52
Q

Mental Accounting Bias (Description)

A

Information processing bias. People treat one sum of money differently from another sum based solely on the mental account the money is assigned to. Separate assets or liabilities into buckets based on subjective criteria.

Solution: GBI. Treat risk at the portfolio level and not bucket level.

53
Q

Representativeness Bias (Description)

A

Tendency to overweight the importance
of the most recent observations and information relative to a longer-dated
or more comprehensive set of long-term
observations.

54
Q

Framing Bias (Description)

A

Person may answer a question differently based solely on the way in which it is asked. Committee-oriented decision-making processes.

55
Q

Availability Bias (Description)

A

Information-processing bias. Mental shortcut when estimating the probability of an outcome based on how easily the
outcome comes to mind. Easily recalled outcomes or things are often perceived as being more likely.

Ex.: AVC or Liquidity Squeezes.

Familiarity: Form of availability bias. Home bias.

CFA L3 Matheus (18 decks)

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