Topic 6: Portfolio Construction for Private Investors Flashcards

1
Q

Portfolio Construction

  • Two key decisions
  • common approach
A

Two key decisions:
1. Asset allocation (to meet risk profile / income needs)
2, Portfolio construction
Common Approach
- Derive asset allocation from risk profile
- Then model implications, although some let income needs drive initial asset allocation

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Asset Allocation - Main Issues (6)

A
  1. What is an asset class?
  2. Basic approach
  3. Model output vs. what is implemented after client discussions
  4. Strategic vs. tactical vs. rebalancing disciplines
  5. Explaining it all to obtain client buy-in
  6. MVO is at heart of almost all asset allocation
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is an Asset Class (6)

A
  1. Reasonably homogeneous risk/return characteristics
  2. Diversifying
  3. Total should cover universe, subject to costs etc.
  4. Liquid so weights can be adjusted
  5. Alternative assets are NOT an asset class
  6. Business implications of classification: –Infrastructure –5%-15% to alternatives?
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Strategic Asset Allocation (4)

A
  1. SAA is main risk control tool
  2. Assume a standard asset allocation based on risk profile, then adjust for client desires (income needs, views, horizon and weird views)
  3. Also consider risk analysis & client reaction to it
  4. How reliable is such analysis?
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Tactical Asset Allocation

A
  1. Huge client and adviser demand for TAA
  2. Management and research teams generally do not want to do, hence may engage in de minimusTAA
  3. To give the appearance of active management, discussions at rebalancing time can be crucial
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Asset Allocation - New Approaches (5)

A
  1. “The Impact of Skewness and Fat Tails on the Asset Allocation Decision”
    •Such a distribution has infinite variance, so cut off the extreme tails
    •Use such a distribution to generate future possible returns, then choose asset allocation to minimize expected conditional VAR assuming those returns represent future
  2. Simulate a return path using above distribution for each asset class, setting the mean, stdev, skew and kurtosis as you like
  3. Also specify correlations between asset classes
  4. VaR: loss expected to be exceeded with a given level of probability (say5%)
  5. CVaR– expected loss conditional on the loss being equal to or in excess of a specified VaR–useful when worried about tail risk
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Asset Allocation - Location (ie the legal structure in which the investments are made)

A
  1. After-tax returns different if stocks held in super account vs own name
  2. Could treat as separate assets and optimize accordingly: thus joint asset allocation and location decision
  3. Need model tax and all constraints (e.g. only have $X in super, if withdraw tax increases etc.)
  4. In reality people do asset allocation first, then location, perhaps back and forward given constraints
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Basic Tax Rules

A
  1. Get as much as possible into low tax vehicles (subject to regulatory risk)
  2. High income assets in low tax vehicles
  3. High growth, low income/turnover assets in the higher tax vehicles if no lower tax alternatives
  4. Direct assets are generally more tax efficient than managed funds (turnover, after tax returns)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Rebalancing

A
  1. Vital to keep in control of risk/return trade off
  2. Countercyclical discipline
  3. No agreed rules:
    - Periodic ( quarterly vs. 2-3 yearly, but in interim anything could happen)
    - Bands (if narrow could be costly, but at least constant monitoring) ie percentage ranges, driven by how expensive it is to trade (wider bands), risk tolerance, volatility of specific asset class
    - Some combination
  4. Common adviser view? Don’t get too fancy, once or twice a year OK after costs, tax and client attention spans
  5. Rebalancing corrects a natural bias hat high risk assets tend to generate higher returns over time, and will dominate portfolios
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Portfolio Construction - Main Issues

A
  1. Must diversify within asset classes
  2. Direct vs. funds
  3. “Risk budgets”, ”active risk appetite” more insto
  4. Firm products vs. open architecture
  5. APL’s, asset consultant and model portfolios
  6. the central role of model portfolios
  7. Core & satellite approaches
  8. How include “alternatives”& structured products
  9. Gearing?
  10. Dollar cost averaging & implementation
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Managed Funds (4) vs Direct (5)

A

FUNDS

  1. Diversification & professional management
  2. Lack of control (income, tax)
  3. Can be tax inefficient (c.f. index products)
  4. Time savings, reporting etc.

DIRECT

  1. Control (good for tax)
  2. Transparency
  3. No management fee
  4. Time intensive, paperwork
  5. Fun!!! (for some)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Alternatives

A

Cons
1. Often illiquid, not transparent
2. Expensive
3. Impossible to model meaningfully
Why include
1. Clients want as love the idea of “absolute returns” and dreams of being “the smart money”
2. Profitable for firm, juicy placement fees
3. Traditional betas can now be gotten cheaply elsewhere
Solution: Include, but keep to a minimum (5% to 15%)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Structured Products

A
  1. Highly profitable areas of firm
  2. Packaged derivatives products, usually featuring: A nice investment theme; Capital protection or minimum guaranteed income return
  3. Can hide fees in embedded derivatives
  4. Only makes sense if permits access to markets otherwise not obtainable
  5. But remembered designed for firm profit, not the client!!!!
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

SAA vs DAA vs TAA

Text talks of 2 methods - SAA and TAA

A

SAA:

  • very important to overall investment process, long term
  • benchmark allocation
  • might be designed to achieve an objective (eg CPI + 4%) in Investment Policy doc

DAA:

  • more dynamic way of achieving a target.
  • typically done by larger teams
  • mean reversion over a period of time

TAA

  • short term moves / decisions / trading based on a view
  • take a view from market signals; trying to achieve alpha
  • making changes to reflect forecasts of future returns
  • rebalance back to SAA
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

CVaR

A

Conditional Value at Risk

- conditional that you get

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

Asset Allocation

After creating AA from initial client risk profile, must adjust for…

A
  1. desire for higher level of income than standard AA
  2. personal desires of clients
  3. tax situation of client
  4. other fact or circumstance peculiar to the client
    Biggest drivers:
  5. Investment horizon
  6. Risk profile
  7. Need for income
  8. Personal client desires
17
Q

Asset Allocation - key considerations

A
  1. Taxes
  2. Behavioural finance / personalities
  3. Death, estate and death taxes (not in Aus)
  4. Inflation
  5. Risk profiling to address risk tolerance and investment styles
  6. Importance of process, methodology and documentation for revision and assist in future decisions
  7. Individual constraints (eg time, need for income)
  8. Largest asset = principal residence
18
Q

Alternatives - issues with including quantitatively into AA

A
  1. Wide dispersion of returns amongst managers
  2. Some asset classes have limited data (mgrs. may not report)
  3. Survivorship bias and self selection
  4. Assets infrequently valued
  5. Non linear and non normal payoffs (ie past data may be poor indicator)
19
Q

Investment Policy Statement

  • Define
  • Include
  • Advantages
A

Define
- IPS is a client specific summation of circumstances, objectives, constraints and policies that govern the relationship between client and adviser.
Include
- financial objectives; portfolio constraints; degree of risk
- operational guidelines
- framework for monitoring and review
Advantages
- IPS is transportable, easy to understand for 2nd opinion
- Protects client & individual adviser (reference doc for the future)

20
Q

IPS: Set Risk and Return Objective

A
  1. Returns
    - required vs desired
  2. Risk
    - Ability vs willingness to take risk
21
Q

IPS: Constraints

A
  1. liquidity (transaction costs, price volatility, emergency reserves, illiquid holdings)
  2. time horizon (LT vs ST, stage of life)
  3. taxes (income, gains, wealth transfer, property)
  4. legal and regulatory environment
  5. unique circumstances