Topic 6: Portfolio Construction for Private Investors Flashcards
Portfolio Construction
- Two key decisions
- common approach
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
Asset Allocation - Main Issues (6)
- What is an asset class?
- Basic approach
- Model output vs. what is implemented after client discussions
- Strategic vs. tactical vs. rebalancing disciplines
- Explaining it all to obtain client buy-in
- MVO is at heart of almost all asset allocation
What is an Asset Class (6)
- Reasonably homogeneous risk/return characteristics
- Diversifying
- Total should cover universe, subject to costs etc.
- Liquid so weights can be adjusted
- Alternative assets are NOT an asset class
- Business implications of classification: –Infrastructure –5%-15% to alternatives?
Strategic Asset Allocation (4)
- SAA is main risk control tool
- Assume a standard asset allocation based on risk profile, then adjust for client desires (income needs, views, horizon and weird views)
- Also consider risk analysis & client reaction to it
- How reliable is such analysis?
Tactical Asset Allocation
- Huge client and adviser demand for TAA
- Management and research teams generally do not want to do, hence may engage in de minimusTAA
- To give the appearance of active management, discussions at rebalancing time can be crucial
Asset Allocation - New Approaches (5)
- “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 - Simulate a return path using above distribution for each asset class, setting the mean, stdev, skew and kurtosis as you like
- Also specify correlations between asset classes
- VaR: loss expected to be exceeded with a given level of probability (say5%)
- CVaR– expected loss conditional on the loss being equal to or in excess of a specified VaR–useful when worried about tail risk
Asset Allocation - Location (ie the legal structure in which the investments are made)
- After-tax returns different if stocks held in super account vs own name
- Could treat as separate assets and optimize accordingly: thus joint asset allocation and location decision
- Need model tax and all constraints (e.g. only have $X in super, if withdraw tax increases etc.)
- In reality people do asset allocation first, then location, perhaps back and forward given constraints
Basic Tax Rules
- Get as much as possible into low tax vehicles (subject to regulatory risk)
- High income assets in low tax vehicles
- High growth, low income/turnover assets in the higher tax vehicles if no lower tax alternatives
- Direct assets are generally more tax efficient than managed funds (turnover, after tax returns)
Rebalancing
- Vital to keep in control of risk/return trade off
- Countercyclical discipline
- 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 - Common adviser view? Don’t get too fancy, once or twice a year OK after costs, tax and client attention spans
- Rebalancing corrects a natural bias hat high risk assets tend to generate higher returns over time, and will dominate portfolios
Portfolio Construction - Main Issues
- Must diversify within asset classes
- Direct vs. funds
- “Risk budgets”, ”active risk appetite” more insto
- Firm products vs. open architecture
- APL’s, asset consultant and model portfolios
- the central role of model portfolios
- Core & satellite approaches
- How include “alternatives”& structured products
- Gearing?
- Dollar cost averaging & implementation
Managed Funds (4) vs Direct (5)
FUNDS
- Diversification & professional management
- Lack of control (income, tax)
- Can be tax inefficient (c.f. index products)
- Time savings, reporting etc.
DIRECT
- Control (good for tax)
- Transparency
- No management fee
- Time intensive, paperwork
- Fun!!! (for some)
Alternatives
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%)
Structured Products
- Highly profitable areas of firm
- Packaged derivatives products, usually featuring: A nice investment theme; Capital protection or minimum guaranteed income return
- Can hide fees in embedded derivatives
- Only makes sense if permits access to markets otherwise not obtainable
- But remembered designed for firm profit, not the client!!!!
SAA vs DAA vs TAA
Text talks of 2 methods - SAA and TAA
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
CVaR
Conditional Value at Risk
- conditional that you get