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TR17-R18 Asset Allocation
TR17-R18 Asset Allocation
Asset Allocation
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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.
Overview
1. Introduction
2. Asset Allocation
3. Asset Allocation and the Investor’s Risk and Return Objectives
4. The Selection of Asset Classes
5. The Steps in Asset Allocation
6. Optimization
7. Implementing the Strategic Asset Allocation
8. Strategic Asset Allocation for Individual Investors
9. Strategic Asset Allocation for Institutional Investors
10. Tactical Asset Allocation
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2. What is Asset Allocation
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Strategic vs. Tactical Asset Allocation
Tactical Asset Allocation: Short-term adjustments to asset class weights based on short-term
expected relative performance among asset classes
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3. Asset Allocation and Investor’s Risk and Return Objectives
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Asset-Only and Asset/Liability Management Approaches to
Strategic Asset Allocation
• AO approach does not explicitly involve modeling liabilities
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ALM approach favored when…
• Investor has below average risk tolerance
• Penalties for not meeting liabilities are high
• Market value of liabilities are interest rate sensitive
• Risk taken in the investment portfolio limits the investor’s ability
to profitably take risk in other activities
• Legal and regulatory requirements and incentives favor holding
fixed-income securities
• Tax incentives favor holding fixed-income securities
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3.2 Return and Strategic Asset Allocation
Qualitative return objectives…
Example 3
Update strategic asset allocation to reflect significant shifts in return and risk requirements
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3.3 Risk Objectives and Strategic Asset Allocation
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Downside risk: risk related to losses or worse than expected outcomes only
Short-fall risk
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Example 4: Applying the safety-first criterion
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3.4 Behavioral Influences on Asset Allocation
If client displays… Investment advisor should…
Example 5
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4. Selection of Asset Classes
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4.1 Criteria for Specifying Asset Classes
• Assets within an asset class should be relatively homogeneous
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Risk, Costs, and Opportunities of International Assets
• Opportunities
Increased correlation
Potentially better valuation than domestic markets in global equity
Diversification markets
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Risk, Costs and Opportunities of International Assets
• Conditional Return Correlations
Correlations appear to depend on global volatility which reduces
international diversification benefits
• Investment Characteristics of Emerging Markets
Higher returns, higher stand-alone risk, lower correlations
But there are several issues and risks:
Investability
Non-normality of returns
Growth illusion
Contagion
Currency issues
Changes from market integration
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4.3 Alternative Investments
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5. The Steps in Asset Allocation
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6. Optimization
6.1 The Mean-Variance Approach
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6.1 The Mean-Variance Approach
Unconstrained MVF
Sign-Constrained MVF
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Exhibit 11.
UK Capital
Market
Expectations
Understanding
Corner
Portfolios
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Corner portfolios define segment where
1) Portfolios hold identical assets
2) Rate of change of asset weights is
constant
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What are the asset class weights in an efficient portfolio with an expected return of 7%?
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Do rest of Example 8
What are the asset class weights in an efficient portfolio with an expected return of 7%?
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Do rest of Example 8
General points related to Efficient Frontier
• Asset allocations are highly sensitive to small changes in input data… which in turn are hard
to estimate!
– Most important input is expected return which is the most difficult to estimate
• Do Examples 9 and 10
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6.2 The Resampled Efficient Frontier
• Efficient frontier is very sensitive to inputs; REF tries to
address this problem
• REF is based on simulation and data set of historical
returns
• Advantages
– Portfolios resulting from REF tend to be more diversified
– Stable relative to portfolios from MVO approach
• Disadvantages
– Lack of theoretical underpinning for the method
– Relevance of historical return data
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6.3 Black-Litterman Approach
• Overall objective is to come up with efficient portfolios
– Quantitative approach to deal with the problem of estimation error
– Unconstrained Black Litterman (UBL)
– Black Litterman (BL)
• UBL
– No constraints on assets weights negative weight (short position) is possible
– Start with market weight of a global index and make adjustments based on
expectations
• BL
– Can not short an asset class
– Curriculum focuses on this approach
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Exhibit 21
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Exhibit 22: Equity market weights of five major markets across the world
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Covariance matrix + capitalization weights Equilibrium expected returns
Exhibit 23
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What is the impact of
your view on the relative
weights?
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Exhibit 28. Efficient Portfolio
Weights with BL View-Adjusted
Returns
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Summarizing BL Benefits…
• Efficient allocations along frontier are more diversified compared
with those resulting from MVO using historical mean returns
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6.4 Monte Carlo Simulation
Monte Carlo is a statistical method which allows you model real-world constraints (such as
taxes) which are difficult to model analytically
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Exhibit 29 Refresher on log scale:
Log scale
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6.5 Asset Liability Management
• Mean-variance surplus optimization extends traditional MVO to
incorporate investor’s liabilities surplus efficient frontier
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Exhibit 31
Review examples
preceding Examples 14
and 15; and material
preceding examples
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ALM with Simulation
• Determine the surplus efficient frontier and select a limited set of efficient
portfolios, ranging from the MSV portfolio to higher-surplus-risk portfolios,
to examine further.
• Conduct a Monte Carlo simulation for each proposed asset allocation and
evaluate which allocations, if any, satisfy the investor’s return and risk
objectives.
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6.6 Experience Based Approaches
• Use tradition, experience and rules of thumb in making SAA
recommendations
1. Use 60/40 as neutral starting point allocation
2. Increase bond allocation with increasing risk aversion
3. High time horizon increase stock allocation
4. Stock allocation = 100 - Age
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Summary of Optimization Models
Methods Comments
Mean Variance Identify portfolios with maximum return for a given level of risk
Optimization (MVO) Corner portfolios
Theoretically pleasing (will see this in all books on PM)
Major issue: EF is very sensitive to input data
Resampled Efficient Based on simulation and historical returns
Frontier (REF) REF relatively less sensitive to input data and portfolios more diversified
Not as theoretically elegant as MVO
Black Litterman Aproach Start with diversified market portfolio and work backwards do determine
(BL) expected returns; incorporate your view; recreate EF
Less sensitive to input data
Portfolios more diversified relative to MVO
Monte Carlo Simulation Run MLS based on scenarios for investment returns inflation and other
(MLS) relevant variables range of outputs
Complements MVO; determine portfolio values in multi-period environment
Asset Liability Explicitly model liabilities
Management (ALM)
Experience-Based Use tradition, experience and rules of thumb
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7. Implementing the Strategic Asset Allocation
Passive Investing Active Investing Semi-Active Investing
tracking portfolio of market portfolio of market securities that tracking portfolio of market
securities—whether self-managed, a reflects the investor’s perceived securities that permits some under-
separately managed account, an special insights and skill and that also or overweighting of securities
exchange-traded fund, or a mutual makes no attempt to track any asset- relative to the asset-class index but
fund— designed to replicate the class index’s performance with controlled tracking risk
returns to a broad investable index
representing that asset class; derivatives-based position (such as derivatives-based position in the
cash plus a long swap) to provide asset-class plus controlled active risk
derivatives-based portfolio consisting commodity-like exposure to the in the cash position (such as actively
of a cash position plus a long asset class plus a market-neutral managing its duration)
position in a swap in which the long–short position to reflect active
returns to an index representing that investment ideas
asset class is received;
Adjust portfolio because asset price changes have moved portfolio weights away
from target weights
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8. Strategic Asset Allocation for Individual Investors
the part of wealth flowing from current and future labor income, and the
changing mix of financial and labor-income-related wealth as a person
ages and eventually retires
any correlation of current and future labor income with financial asset
returns
tax situation
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8.1 Human Capital Financial Capital and
Human Capital with Age
Investors with safe labor income (thus safe human capital) will invest more of their financial portfolio
into equities. A tenured professor is an example of a person with safe labor income; an at-will
employee in a downsizing company is an example of a person with risky labor income.
Investors with labor income that is highly positively correlated with stock markets should tend to
choose an asset allocation with less exposure to stocks. A stockbroker with commission income is
an example of a person who has that type of labor income.
The ability to adjust labor supply (high labor flexibility) tends to increase an investor’s optimal
allocation to equities
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8.2 Other Considerations in Asset Allocation for Individual Investors
Mortality risk is the risk of loss of human capital if an investor dies prematurely. Of
course, it is the investor’s family that bears the effects of mortality risk. Life insurance
has long been used to hedge this risk.
Longevity risk is the risk that the investor will outlive his or her assets in retirement.
Mitigate using life annuity which guarantees monthly income for life
Fixed annuity
Example 16
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9. Strategic Asset Allocation for Institutional Investors
• Insurance Companies
• Banks
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9.1 Defined-Benefit Plans
• Regulatory constraints
– Denmark: 60% minimum in domestic debt
• Liquidity constraints
– High liquidity requirement low allocation of illiquid assets
• ALM
Exhibit 47
Example 17
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9.2 Foundations and Endowments
• High long-term return to spending and inflation
– Recognize appropriate inflation rate
• SAA partly depends on resources available
– Smaller endowments will generally have a constrained opportunity set (long only) and
a relatively low percentage in alternative investments
• Example 18: Constructing an IPS and deciding on an asset allocation
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9.3 Insurance Companies
An insurer’s strategic asset allocation must complement and coordinate with the insurer’s
operating policy. Investment portfolio policy thus seeks to achieve the most appropriate mix of
assets
1) to counterbalance the risks inherent in the mix of insurance products involved and
2) to achieve the stated return objectives
The insurer must consider numerous factors in arriving at the appropriate mix, the most
important of which are
1) asset/liability management concerns
2) regulatory influences
3) time horizons
4) tax considerations
Portfolio segmentation:
(Life insurance companies)
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Advantages of portfolio segmentation
provides more-accurate measurement of profitability by line of business. For example, the insurer
can judge whether its returns cover the returns it offers on products with investment features such as
annuities and guaranteed investment contracts (GICs)
aids in managing interest rate risk and/or duration mismatch by product line
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Example 19. Sample Asset Allocation for a Life Insurance Company
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9.4 Banks
Bank’s securities portfolio plays an important role in:
1) managing the balance sheet’s overall interest rate risk ALM Approach
3) producing income
Banks’ portfolios of loans and leases are generally not very liquid and may carry substantial credit
risk. Therefore, a bank’s securities portfolio plays a balancing role in providing a ready source of
liquidity and in offsetting loan-portfolio credit risk.
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Example 20. Sample Asset Allocation for a Commercial Bank
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10. Tactical Asset Allocation
• Deliberately underweighting or overweighting asset classes relative to their
target weights in the policy portfolio in an attempt to add value
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1. Market prices tell explicitly what returns are available
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Other factors:
1. changes in assets’ underlying risk attributes
2. changes in central bank policy
3. changes in expected inflation
4. position in the business cycle
Examples 21 and 22
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Conclusion
• Learning objectives
• Summary
• Examples
• Practice problems
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