Week 5 Flashcards
all of the available asset allocation approaches that can be employed to assist the asset allocation decision
A
Mean-variance analysis
B
Liability-driven investing (e.g. DB funds)
C
Benchmark-related
D
Fundamental risk approach
E
Two-stage approach
F
Scenario analysis
G
Dynamic strategies
H
Fill the buckets
Is the amount of “liability” in a DB fund totally determined by the portfolio manager or the board?
liability is not a choice. can be determined by some extent e.g. close DB fund to future new employees
the liability in a DB fund is an
actuarial estimate of the present value of future retirement benefits payable to members.
Is the “liability” driven by discount rate applied to projected benefits?
valuation of projected liabiiities rely on numerator (salary growth, longevity of employees)
denominator the discount rate
Why is the “liability” viewed as a negative asset (holding this asset results in paying out cash flows).
negative cash flows in the future
distinguish between DB fund managers and active equity managers?
db funds have their own characteristics/projected liabilites to meet, no benchmark performance
active australian equity managers given ASX 200 and ASX 100 benchmark as performance target
should all DB funds choose the minimum risk portfolio?
NO, minimum risk portfolio in DB funds is the portfolio or asset allocation that will provide perfect match between the assets and projected liabiltes
each db funds has its own board to go through negotaition process with sponsoring entity. opinion of representative from union of employees. use best match of assets and liabilites as a STARTING POINT then come up with asset allocation process
The asset allocation of DB funds is the outcome that
that balances the objectives of all stakeholders, i.e. sponsoring entity, members, government, portfolio manager, etc.
Mean-variance optimization can be applied to a DB fund asset alloction analysis if
the projected liability can be characterized and included as a negative asset in its total portfolio. This analysis helps to understand how the liability contributes to the total portfoio risk and return (its covariance with all the other assets in the portfolio).
helps portfolio manager to understand the projected liability to the total portfolio risk and return.
Fundamental risk approach may improve the risk-return tradeoff of portfolios by
switching to assets of similar expected return and lower standard deviations
apply on top of quantitiative asset allocation output to improve economic exposure
Fundamental risk approach (mostly qualitative) may be applied in
addition to a quantitative asset allocation approach, eg. mean-variance optimization, to improve the diversification of the protfolio marginally.
List methods of forecasting the ER of a group of assets
- implied view method
- black-litterman approach that combines market equilibrium and investors expectation
- Bayesian technique, for instance, James Stein estimator
Confidence interval around per-annum ER
usually narrows with investment horizon
wealth is
accumulation of return over multiple periods.
confidence interval around wealth
may increase or decrease with investment horizon given long term view and returns are not serially correlated
depends how ER returns are positive or negative.
variance is a
linear function of time only if returns and independently and individually distributed.
risk as measured by a shortfall constraint
depends on the mean and variance of means
shortfall constraint = probability of loss
method most likely to be an error maximiser/ generate an error maximiser/generate errors because of the errors in the inputs i.e. STD and ER
i.e. generate portfolios than remain largely a reflection of any errors or inconsistencies in the inputs
mean-variance optimisation based on historical inputs with asset weighting constraints imposed e.g. 20%
higher risk of errors in input. these will fit into mean-variance optimsisation –> mean variance optimisation = error maximiser
which of the following optimisation methods is most likely to generate portfolios than remain largely a reflection of any errors or inconsistencies in the inputs?
what are the inputs
STD and ER in mean variance optimisation model.
mean-variance optimisation with an additional constraint in benchmark risk i.e. tracking error versus the peer benchmark
why does this not make the mean-variance optimisatoin an error maximiser
even though you are using historical inputs, tracking error in place, more likely to generate something meaningful.
In instances where the expected returns do not seem reasonable, how might you respond in order to establish a more reasonable basis for analysis? (Implied views method)
option 6
Use another return modeling approach
In instances where the expected returns do not seem reasonable, how might you respond in order to establish a more reasonable basis for analysis? (Implied views method)
option 5
Adjust inputs towards something considered to be more reasonable
(Note: This probably needs to be done within a parametric approach, so that E[R]s and covariances (or standard deviation and correlation) are all adjusted towards their “underlying” levels, e.g. push up both E[R] and beta on DP. Under the non-parametric, data-based approach, only the mean and hence E[R] can be readily adjusted.)
In instances where the expected returns do not seem reasonable, how might you respond in order to establish a more reasonable basis for analysis? (Implied views method)
option 4
Possibly change the reference portfolio. (Note: This may be problematic. The reference portfolio has probably been selected for a specific reason, such as representing the peer group, etc. Also you should ideally use the reference portfolio relative to which assets are priced in the market, in the spirit of the CAPM. However, the identity of this portfolio is quite unclear
In instances where the expected returns do not seem reasonable, how might you respond in order to establish a more reasonable basis for analysis?
option 2
Try a different estimation interval (e.g. yearly data) or time periods, and see if estimates improve
In instances where the expected returns do not seem reasonable, how might you respond in order to establish a more reasonable basis for analysis?
option 1
Perhaps do nothing: the implied views approach may still provide a reasonable basis for your analysis, even if not perfect. Ask if any errors may make a significant difference to the outcomes
Data-based (non-parametric) analysis
Diversifying into commodities
but
− Increase in Sharpe ratio does NOT eventuate without the +0.33% adjustment to E[R] (try for yourself to confirm)
− Hence the benefit of adding commodities can depend on investor preferences, objectives and expectations. For instance, funding source may depend on whether investor prefers higher returns or lower risk
Data-based (non-parametric) analysis
Diversifying into commodities
appears
− Portfolio risk and return are both decreased if funded from all assets or equities, but reverse happens if funded from FI.
− Sharpe ratio increase when funded by all assets, equities or FI. It seems that the switching strategy does improve the risk-return trade-off for investor’s portfolio.
Data-based (non-parametric) analysis
Switch -10% from AE into WE (+6% unhedged, +4% hedged).
Equity switch On portfolio
Portfolio returns and Sharpe ratio both rise notably when return on WE is increased by 0.50%. Thus such a switch may be worthwhile if one had a more positive view of WE
This hints that the results from such analysis can be quite sensitive to (questionable) E[R] estimates.
Data-based (non-parametric) analysis
Switch -10% from AE into WE (+6% unhedged, +4% hedged).
Equity switch On baseline return inputs
On baseline return inputs, moving towards a more global equity portfolio reduces both return and risk on baseline inputs, but Sharpe ratio decreases. Hence limited benefit. (Note: Benchmark portfolio is “optimal” by construction under implied views, thus any change of weights amongst the existing assets will decrease the Sharpe ratio.)
Parametric analysis of adjustments to the baseline portfolio and general discussion
The parametric approach permits evaluation of
The parametric approach permits evaluation of assets for which a full data history does not exist, providing you can form estimates for expected returns and covariance
Parametric analysis of adjustments to the baseline portfolio and general discussion
Introduce a 10% weighting to emerging markets (EM). Fund the investment from all equities as follows: -5% AE, -3% WE, unh, -2% WE, h. (After the analysis is complete, reverse the switch so weights are back to the baseline).
• Introduce a 10% weighting to index-linked bonds (ILB). Fund the investment from fixed interest as follows: -5% AFI, -5% WFI.
What benefits arise from adding these two new assets to the portfolio?
Benefit 3
Adding ILBs, switching from FI: Expected return, risk and the Sharpe ratio all decrease, albeit marginally. This is a switch where related FI assets are replaced, hence diversification benefits are limited and portfolio remains concentrated. Hence no substantial benefit.
Parametric analysis of adjustments to the baseline portfolio and general discussion
Introduce a 10% weighting to emerging markets (EM). Fund the investment from all equities as follows: -5% AE, -3% WE, unh, -2% WE, h. (After the analysis is complete, reverse the switch so weights are back to the baseline).
• Introduce a 10% weighting to index-linked bonds (ILB). Fund the investment from fixed interest as follows: -5% AFI, -5% WFI.
What benefits arise from adding these two new assets to the portfolio?
Benefit 2
Adding EMs, switching from other equities: Expected return, risk and the Sharpe ratio all increase. Hence this seems like a good move, providing the additional risk is acceptable.
Parametric analysis of adjustments to the baseline portfolio and general discussion
Introduce a 10% weighting to emerging markets (EM). Fund the investment from all equities as follows: -5% AE, -3% WE, unh, -2% WE, h. (After the analysis is complete, reverse the switch so weights are back to the baseline).
• Introduce a 10% weighting to index-linked bonds (ILB). Fund the investment from fixed interest as follows: -5% AFI, -5% WFI.
What benefits arise from adding these two new assets to the portfolio?
Benefit 1
Potential diversification benefits: Adding new assets offers the potential for a more efficient portfolio, with a higher Sharpe ratio. This can work because the benchmark portfolio does not hold all available assets, hence may be sub-optimal. In other words, adding new assets may generate a higher efficient frontier.
To what extent might the following investments deliver ‘alpha’ versus ‘beta’, or something else?
opportunistic direct property fund that engages in property acquisition and development.
Combination of both alpha and beta. There is property beta, and exposure to fundamental factors such as the economy.
There is also an element of returns attributable to the management process, although they do not fully adhere to the traditional view of alpha as skillbased.
Some returns also arise from adding economic value to the underlying assets themselves.
To what extent might the following investments deliver ‘alpha’ versus ‘beta’, or something else?
Macro hedge fund that takes market-timing positions based on macroeconomic views.
Seeks alpha by timing beta. Hence will carry beta exposures, although which ones and in what quantum will vary continually.
Probably a hybrid of alpha and beta, and there is no clear demarcation between the two. Hence does not fit into the alpha/beta taxonomy very well.
To what extent might the following investments deliver ‘alpha’ versus ‘beta’, or something else?
Long-short hedge fund where each $1 of capital is invested in cash, but is used to support up to +$5 in long and -$5 in short equity positions.
‘Equity long-short’ hedge fund – Should be pure alpha, providing market exposure neutralized by longs and shorts. But beta exposure could creep in, if portfolio is not purged of all market exposure.
To what extent might the following investments deliver ‘alpha’ versus ‘beta’, or something else?
Enhanced passive equity fund, that is based around replicating a market index (e.g. S&P 500, S&P/ASX 300), but deviates occasionally from index weight when there is profit to be made. For instance, they may try to exploit temporary mispricing due to pressures stemming from large orders by other players (kind of a market-making or liquidity provision role); arbitrage between different classes of securities in the same company; or take advantage of IPOs (initial public offerings).
Both. Mainly beta, with a modest amount of alpha included (‘alpha-lite’)
beta and alpha
beta is exposure to the global market portfolio.
And, any positive expected return from exposure to a risk uncorrelated with this portfolio is alph
what is exotic beta
an exposure to a risk factor that is both uncorrelated with global markets and has a positive expected return – such as commodities –
The excess return from an exotic beta is alpha, and therefore, exotic betas should be included as a source of alpha in a portfolio.
benefit of exotic beta (source of alpha)
being relatively passive strategies, lower Transaction costs, liquidity requirements and management fees should be minimal, and capacity should be quite large
Since the returns are uncorrelated with those of the market, a modest exposure to an exotic beta should have minimal impact on the overall risk of most investors’ portfolios.
how to create a more efficient portfolio
Combining traditional beta with alpha from active management and relatively passive exposures to exotic betas
1) Beta: Basic Market Exposureexposure to developed equity markets can be obtained today by passively holding an index portfolio, traditional beta generates little cost in terms of fees, transaction costs or taxes. So, it makes sense for investors to include some beta as a return source in their portfolios. However, it should be complemented, and diversified, with other beta exposures and with active management strategies.
exposure to developed equity markets can be obtained today by passively holding an index portfolio, traditional beta generates little cost in terms of fees, transaction costs or taxes.
therefore investors include some beta as a return source in their portfolios. However, it should be complemented, and diversified, with other beta exposures and with active management strategies.
As we said earlier, exotic beta as a source of return shouldn’t persist because it is not an equilibrium phenomenon.
example
commodities are uncorrelated with equities and positive excess returns from commodities have been available for many decades, it’s likely that this premium will decline over time.
This will happen as commodity prices are bid up to equilibrium levels by investors trying to capture this exotic beta premium
Why does exotic beta exist?
risk premium for volatility exposure to individual assets s the primary source of the return in exotic betas
demand for liquidity
existence of returns from exotic beta is that the global market returns have fat tails on the downside, and investors are getting paid a premium to accept the risk of a market crash, which is concentrated in certain exotic betas
potential sources of exotic beta
commodities and catastrophe insurance
selling volatility in various markets, taking exposure to corporate default risk, investing in corporate mergers and acquisitions, and tilting toward stocks with characteristics such as value or small capitalization.
Increasingly, institutional portfolios are being built by considering active
(alpha) returns separately from broad market (beta) returns
The use of derivative securities to hedge and replicate market risk means that value added through active management need not be tied to the asset class in which the active management takes place
an institution that believes it has access to a fund manager who can produce alpha in some less prominent asset category
alpha with or without any commitment to the asset class itself.
Index fund
(e.g., the well-known S&P 500 fund provided by Vanguard), which provide beta exposure and require the investor to put up actual cash,
The portfolio return is divided into three parts:
the riskless return,
the risk premium from passive beta exposure,
and the alpha return from either (1) active management of individual securities or (2) tactical timing of beta exposures.
Beta Risk
Source of return
Skill required
Confidence in earning the expected return
Cost
Allocation of return among investors
Shape of the return distribution
Alpha Risk
Alpha should not be thought of as the return from active management, but rather as a
a return source that is not associated with any common risk factor
Investors Want Returns That Are:
- Positive over the long-term
- Uncorrelated to their existing portfolio exposures
Three Potential Sources for these Returns:
Portfolio modifications to attain more efficient portfolios
Using leverage
switch from A to C; if leverage is available, switch from C to D.
Portfolio modifications to attain more efficient portfolios
swapping assets of different exposure to a risk factor, but similar ER
e.g. office building or shopping centre. too much exposure to property market. I would like to diversify economic risk of total portfolio B by swapping asset to infrastructure project (similar ER as Office building but lower risk)
Infrastuture projects financed by gov, private entities,. Expected risk of infrastrucure project is less sensitive to economic development in economy
Other asset allocation methods
‘Fill the buckets’
It is a
It includes
It is a mental framework of asset allocation to present to investor given their circumstances and requirements about what investment opportunities are available
It includes the investment opportunity universe, instead of the traditional equity/bond/cash classifications. The framework allows broad market exposure and the opportunities to exploit market inefficiencies.
Other asset allocation methods
‘Fill the buckets’
there is no
No precise asset returns assumptions or percentage allocations are made because each investor has a unique circumstance.
You havea complete set of investment opportutnies for investor to choose from.
Does not produce any asset allocation
Dynamic strategies: Lifetime asset allocation
Recognises
Recognises that investment oportutnies changes, risk preference, circumstances change In different stages of their life
Dynamic strategies: Lifetime asset allocation
conditional asset allocation, allocation changes over time
Provides changes in portfolio adapting to changes in their life stage from growth to defensive
