Topic 1 Flashcards
Tactical asset allocation
- Active strategy to deviate from our long-term allocation based on changing market circumstances.
- It is all about “Market Timing”
- Tilt weights towards assets you expect to do well.
Strategic asset allocation
- Long-term allocation to broad asset classes.
- Maximizes risk return trade-off given inherent risk return asset class characteristics.
- Periodical rebalancing towards long-term weights.
- Explains 90% of time-series variation of the performance in a single mutual fund
- Explains 40% of time-series variation of the 10 year performance in different mutual funds
Rule 1 - Do not neglect equities
Equities have an average premium of 5.5% over bonds
Rule 2 - Diversify idiosyncratic risk
- 30-50 stocks to eliminate firm-specific risk
- systematic risk cannot be diversified
Rule 2b - Diversify country risk
- Diversification benefit: volatility of global equity is lower than that per country
- Allocation of 40% foreign stock is appropriate
Problem: correlation is increasing between countries due to globalisation, so less benefit
Rule 2c - Diversify market development risk
- Emerging/Frontier markets: offers some diversification at moderate risk, however correlation is also expected to grow due to globalization
- Higher returns are just priced risk premiums related to political and liquidity risk
Rule 3 - Diversify into other asset classes
Combine (alternative) asset classes that are poorly correlated
The endowment model
highly-diversified, long-term portfolios that differ from a traditional stock/bond mix in that they include allocations to alternative asset categories as well as absolute return strategies.
Hedge funds conclusions
- Performance has a downward trend and is much lower than ETFs
- High losses in times of crisis
- High correlation with 60/40 portfolio.
- Underperformance the market. No evidence that a manager can beat the market regularly.
- The managements are not “active” in the sense we need. Passive is better.
Private equity evidence
- PE outperforms standard public equity benchmarks before costs.
- PE’s performance has gone down over the last decade and is equal to the S&P500.
- In their risk category, PE’s underperforms index of small value firms
- Despite decreasing returns, a lot of money has flown into PE funds lately.
Private debt what & conclusions
- Direct participation in debt of firms
- Not financed by banks, not issued or traded in an open market.
- Small but growing fast. Bank regulation with negative effects on real economy procyclicality increases demand for private debt.
- LPs primarily consider absolute return measures (IRR)
- Calculating risk adjusted returns is challenging
- Shortfall risk over a long time horizon is a good measure for risk
- Public Market Equivalent (PME) likely to substitute a 1 factor model (CAPM) and currently only method
to accurately reflect risk partially
Real estate advantages
Advantages:
- Private real estate: attractive risk return tradeoff (very good Sharpe Ratios)
- Offer high dividends (liquid income) – good for pension funds
and retired investors
Commodities
- Low correlation for livestock, agriculture and precious metals
- High correlation for oil and industrial metals
Bonds
- Negative correlations with equities – Perfect diversifiers.
- Portfolio 40/60 has better sharpe ratio than stocks
- Returns are very low, because of the low beta (CAPM)
- Bonds are especially good diversifiers when inflation is procyclical
Bonds - inflation is countercyclical
Negative inflation shock signals bad news about the future economy
- Equities drop in value because of lower than expected growth prospects
- Bonds drop because higher than expected inflation raises yields.
- Positive stock-bond correlation
- Examples: – oil shocks push up inflation and depressed the economy.
Bonds - inflation is procyclical
Positive inflation shock signals good news about the future economy.
- Equities surge because of better than expected growth prospects
- Bonds drop because higher than expected inflation raises yields
- Negative stock-bond correlation
- Example: higher inflation signals the economy picking up
Inflation-linked bonds
- Good hedge against inflation (long-term), however coupons (not principal) will decrease with deflation
- TIPS offer unusually high expected returns and low risk relative to nominal bonds
- Low volatility and low correlations with other assets (makes it a good diversifier)
- Investing too much in TIPS will make the portfolio unbalanced (due to its small market cap)
Private equity motives
- Investors seek Leverage: You want to take on additional risk, but you are limited by internal rules. You can implicitly take on leverage by investing in PE
- PE returns are artificially smooth and don’t move as public market returns, as they are not listed
- A portfolio that mixes public with private equity will “look” less risky, at least in the short run
- The manager of such mixed fund is less likely to be forced to sell at rock-bottom prices because of imposed
risk constraints or solvency rules
Real estate disadvantages
- Listed REITs: high volatility, high correlation with the market
- Low capital appreciation
Harvard Endowment
Main question is this case
Should HMC add inflation-linked bonds as an additional asset class?
Asset classes
Traditional & Alternatives
- Traditional: Cash, Bonds, Equities
- Alternatives: Private Equity, Private Debt, Real Estate, Commodities, Hedge Funds, Crypto
What is the role of the policy portfolio for HMC?
- Long-run (or ‘strategic’) asset allocation of the endowment over main asset classes
- Benchmark for performance measurement
How is policy portfolio determined?
- Specify objective (utility function)
- Specify asset classes
- Capital market assumption (ER, Vol, Correl)
- Optimization (w* or w/o constraints)
- Blacktesting (Simulation)
- Implementation
- Follow (performance management)
Importance of diversification
- Portfolios with large amounts of idiosyncratic risk are inefficient
- Stock index with beta 1 has volatility of 20% and an individual stock with same beta has vol = 38%
- Idiosyncratic risk is higher for small stocks
Mean-Variance analysis for HMC – with target on TIPS
a. Find portfolio with a target return of 6.5% that has minimum variance
b. Analyze correlations
c. Adjust expected returns according to observations. Find the cause and adjust premiums
d. Set constraints and generate optimal weights (minimum volatility for setter expected return)
If you reduce the premiums, the weights will decrease significantly. The other assets for which the premium remains stable or increases will have therefore bigger weights to compensate for reduction
Mean-Variance analysis for HMC – with target on TIPS
b. Analyze correlations
- Large but < 1 correlation with nominal bonds - Diversification benefits
- Negative correlation with cash - In case of increasing real rates, cash will hedge
- Small but > 0 correlation with equities - Increase in real rates is bad for both TIPS and equities
- Positive correlation with other inflation hedging assets (real estate and gold)
Mean-Variance analysis for HMC – with target on TIPS
c. Adjust expected returns according to observations. Find the cause and adjust premiums
After observing high TIPS return, the return on cash was raised to reduce the real rate premium
Mean-Variance analysis for HMC – with target on TIPS
d. Set constraints and generate optimal weights (minimum volatility for setter expected return)
- Under no constraints: Equity and Nominal bonds are very unattractive - Low premiums
- Under policy constraint’s: Equity receives weight just because it has a set minimum
- Under no shorting (only borrowing): Equity and Nominal bonds 0% and full borrowing of cash
- Optimal weights suggest a very high investment in TIPS - Not really suitable
