Portfolio Management Unit – III Session No. 23 Topic: Asset Allocation Unit – III Session No. 23 Topic: Asset Allocation

Session Plan Recap the previous session Asset Allocation Summarizing and Q & A

Asset allocation is a process and a result. In strategic asset allocation, an investor’s return objectives, risk tolerance, and investment constraints are integrated with long-run capital market expectations to establish exposures to IPS-permissible asset classes. The aim is to satisfy the investor’s investment objectives and constraints. Tactical asset allocation (TAA), which involves making short-term adjustments to asset-class weights based on short-term expected relative performance among asset classes. Asset Allocation

The Role of Strategic Asset Allocation in Relation to Systematic Risk Strategic asset allocation’s relative importance, compared with security selection and timing, for producing investment results in practice. Adopting and implementing a strategic asset allocation is an effective way to exercise control over systematic risk exposures. Strategic versus Tactical Asset Allocation Strategic asset allocation sets an investor’s desired long-term exposures to systematic risk. Tactical asset allocation involves making short-term adjustments to asset-class weights based on short-term predictions of relative performance among asset classes. Asset Allocation

The Empirical Debate on the Importance of Asset Allocation Investors need to keep in mind their own specific risk and return objectives and establish a strategic asset allocation that is expected to satisfy both. Sidestepping strategic asset allocation finds no support in the empirical or normative literature. Asset Allocation

ASSET ALLOCATION AND THE INVESTOR’S RISK AND RETURN OBJECTIVES Role in setting objectives – Asset/Liability Management Approaches to Strategic Asset Allocation – Return Objectives and Strategic Asset Allocation – Risk Objectives and Strategic Asset Allocation – Behavioral Influences on Asset Allocation Asset Allocation

1. Asset/Liability Management Approaches to Strategic Asset Allocation In the context of determining a strategic asset allocation, the asset/liability management (ALM) approach involves explicitly modeling liabilities and adopting the optimal asset allocation in relationship to funding liabilities. Investors other than those with significant future liabilities may adopt an ALM approach by treating future needs (such as for income) as if they were liabilities; we call those needs ‘‘quasi-liabilities.’’ In contrast to ALM, an asset-only (AO) approach to strategic asset allocation does not explicitly involve modeling liabilities. In an A approach, any impact of the investor’s liabilities on policy portfolio selection is indirect (e.g., through the level of the return requirement). Compared with ALM, an AO approach affords much less precision in controlling risk related to the funding of liabilities. Asset Allocation

2. Return Objectives and Strategic Asset Allocation Investors have both qualitative and quantitative investment objectives. Qualitative return objectives describe the investor’s fundamental goals, such as to achieve returns that will: – Provide an adequate retirement income (for an individual currently in the workforce). – Maintain a fund’s real purchasing power after distributions (for many endowments and foundations). – Adequately fund liabilities (for investors such as pension plans and insurance companies). – Exceed the rate of inflation in the long term (from the prospectus of an inflation-protected bond fund). Asset Allocation

3. Risk Objectives and Strategic Asset Allocation In addition to the investor’s return objectives, the investor’s risk tolerance enters into creating a policy portfolio. As with return objectives, both qualitative and quantitative risk objectives are important. Many practitioners will qualitatively evaluate an investor’s risk tolerance as below average, average, or above average, based on the investor’s willingness and ability to take risk. To apply a quantitative approach to asset allocation, however, we must quantify an investor’s attitude to risk. The most precise way to do so is to measure the investor’s numerical risk aversion, R A. Numerical risk aversion can be measured in an interview or questionnaire in which the investor expresses preferences among sets of choices involving risky and certain returns. Risk aversion is the inverse of risk tolerance: A lower value of risk aversion means a higher tolerance for risk. Asset Allocation

4. Behavioral Influences on Asset Allocation Behavioral finance, grounded in psychology, focuses on describing individuals’ observed economic behavior Advisers of individual investors in particular, however, may better understand their clients’ investment goals, needs, and reactions to proposed asset allocations if they become familiar with behavioral finance tenets such as loss aversion, mental accounting, and regret avoidance. Behavioral finance asserts that most investors worry more about avoiding losses than acquiring gains. According to behavioral finance, most individuals are risk seekers when faced with the prospect of a substantial loss. Asset Allocation

THE SELECTION OF ASSET CLASSES 1. Criteria for Specifying Asset Classes 2. The Inclusion of International Assets (Developed and Emerging Markets) 3. Alternative Investments Asset Allocation

THE STEPS IN ASSET ALLOCATION 1. Criteria for Specifying Asset Classes Homogenous – Similar Asset Classes. Example: Common Stocks and Equities. Mutually Exclusive - Reduce the effectiveness of strategic asset allocation in controlling risk. Diversifying - Find the minimum tracking risk combination of asset classes for diversifying. Investable Wealth - The asset classes as a group should make up a preponderance of world investable wealth. Portfolio’s Liquidity - The asset class should have the capacity to absorb a significant fraction of the investor’s portfolio without seriously affecting the portfolio’s liquidity Asset Allocation

2. The Inclusion of International Assets (Developed and Emerging Markets) When investing in international assets, investors should consider the following special issues: – Currency risk. Exchange rate fluctuations affect both the total return and volatility of return of any nondomestic investment. Investors in nondomestic markets must form expectations about exchange rates if they decide not to hedge currency exposures. – Increased correlations in times of stress. Investors should be aware that correlations across international markets tend to increase in times of market breaks or crashes. 29 – Emerging market concerns. Among the concerns are limited free float of shares (shares available in the marketplace), limitations on the amount of nondomestic ownership, the quality of company information, and pronounced non-normality of returns. Asset Allocation

3. Alternative Investments Real estate was the other major asset class besides fixed income and equity that investors would list as an asset class. Four alternative asset classes: private equity, real estate, natural resources, and hedge funds. Investors may face an internal resource constraint limiting investment in alternative assets. Asset Allocation

What is Asset Allocation? What are you understanding about two different types of Asset Allocation? What is the key economic role of Strategic Asset allocation? How Strategic asset allocation is distinct from tactical asset allocation? How important is Strategic asset allocation in relate to other investment decisions? What is ALM? Give example for ALM. How return objectives are important in Strategic asset allocation? How to use mean-variance to evaluate asset allocation? What is the behavioral influence on asset allocation? On What basis selection of asset classes are permitted? What factors affect the portfolio selection of asset allocation? Why Investor needs a logical frame work? How the five criteria’s help in effectively specifying asset class? Asset Allocation

Which analysis help an investor in Asset selection? Which three inputs essentially required in asset selection? What is meant by Alternative Investments? Asset Allocation

The steps in asset allocation – Capital market conditions Prediction procedure Expected returns, risk and correlations Investor’s assets, liabilities, networth & risk attitudes Investor’s risk tolerance Optimizer Investor’s asset mix Returns Asset Allocation

What is the need for asset allocation review? What is meant by risk tolerance? Why optimizer used to determine asset allocation and mix? Why the process is called as integrated asset allocation?

Asset Allocation